Much Ado About Inflation: Answers to Common Questions

What is it?

Inflation, by definition, is the increase in the cost of goods or services that we consumers all need to live our lives. Examples include commodities such as food, clothing, household items, and gas. as well as other services like a check up at the doctor, having your taxes prepared, or getting your house painted. When inflation rises, your purchasing power falls—meaning, one dollar buys you less.

How is it measured?

The Bureau of Labor Statistics (BLS) is the U.S. body charged with measuring inflation. It is measured using what is known as the “Consumer Price Index” or “CPI.” The costs of a collection of different goods and services are averaged, the change in the prices of each are examined for a given period of time and then again averaged and further adjusted by region. The result is the CPI for that period.

Why do I hear news about the CPI excluding food and energy prices?

All human beings need to eat and use energy in some form (even those of us who don’t have a car to gas up each week) so why wouldn’t we want to include these two very significant components? Food and energy prices are volatile and therefore can skew the measurement; removing these can help us identify trends we might not otherwise be able to see. Having a sense of general price movement give us a better indication of what’s going on and what to do about it.

Why is it important?

Slow and steady inflation is generally thought to be positive: it means our economy is growing: the risk arises when prices rise sharply and don’t accurately reflect underlying values and this can lead to a bubble and the resulting aftermath when that bubble bursts. Our central bank, the Federal Reserve (the “Fed” for short) tries to ensure inflation stays within certain limits (typically 2-3% annually.) If they feel it is moving too rapidly in one direction or another, they will take measures to try to ameliorate what they believe to be an unsustainable trend.

When inflation is the concern, they attempt to tighten the money supply by raising interest rates, selling government securities (Treasury bonds) or increasing banks’ reserve requirements. Each of these measures serve to reduce the free flow of money and thus, as former Federal Reserve chairman Alan Greenspan might say, reduce a situation that has become too “frothy.”

The economy and markets are currently recovering from the burst of the real estate bubble and the subsequent ripple effects. Thus the problem of late has been not inflation but the opposite, deflation. When it comes to falling prices, the Fed takes measures to try to loosen the money supply to help our faltering economy. And the Fed has taken many steps to try to get people spending and lending money again: interest rates are at historical lows and they’ve pumped money into the system in various ways, most recently through “quantitative easing,” an effort to encourage banks to lend more by buying government securities and increasing the amount of money flowing through the system.

What’s the worry?

If deflation is the problem, why is everyone talking about inflation? The Fed’s job is a precarious one: CPI is just one of the tools they use to try to evaluate what is going on in the economy (i.e. what is going on in the minds of individuals and institutions) to determine what strategies to utilize to keep things in balance.

Even if they do all the “right” things, they have to carefully gauge how much is enough and when to stop. While Alan Greenspan was revered for much of his 18 year tenure, he was blamed afterwards for contributing to the real estate bubble. Many believed he kept interest rates too low for too long and that the easy availability of money led consumers and companies alike to over- leverage themselves.

Right now, Ben Bernanke, our current Fed chairman, is in the difficult position of having to decide what to do next: keep rates where they are and risk another bubble in the long term, or begin to raise them and risk causing already fear-stricken consumers to put their wallets back in their pockets just as they were taking them out again for the first time in a long time.

Rates will have to be raised at some point, and with all the money the Fed has infused into the economy, it’s hard to see how the cycle won’t start again as consumers and businesses begin to feel more confident. It’s a delicate balance to be sure and Bernanke won’t know if these measures work until well after he employs them.

How does this affect me?

The most obvious way inflation affects consumers is the hit you feel to your pocketbook when you go to the grocery store or the gas pump, but inflation also affects your investments. When the Fed tries to stem inflation by raising interest rates, this can affect bonds in your portfolio. The risk of bond prices being hurt by these changes is known as interest rate risk.

Interest rates and bond prices have an inverse relationship: when bonds are first issued, their coupon rate is usually close to interest rates at that time. Because the coupon rate is fixed, if interest rates rise later, the bond price will fall. This is because the market is not willing to pay face value for a bond when newly issued bonds at the same price are paying higher coupon rates. While rising interest rates are generally bad for bonds, they affect different types of bonds differently: longer term bonds can be more significantly impacted than shorter term bonds.

What can I do to protect myself from the effects of inflation?

Lowering a bond portfolio’s duration (a measure of bonds’ sensitivity to interest rate changes) is one way to protect portfolios form rising interest rates. When we talk about interest rate changes, we are talking about changes in the US only; another way to protect a portfolio is by investing in bonds outside the US in addition to US bonds. Investing in commodities is another way to protect against inflation because it provides a hedge: as commodity prices rise, so does the value of a commodities fund. Investing in the market: while cash is fine for money you will be using in the short-term, it is not a fail-safe investment for the long-term because, as discussed above, inflation reduces purchasing power: $1 in the bank becomes worth less with every passing day that inflation is on the rise.