I've read a number of articles lately about how the government's official measure of inflation underestimates the real inflation in the economy. People believe that somehow there's an inflation conspiracy going on, and the government is manipulating the numbers to keep the official rate low.
Well, as with most conspiracy theories, it's bull. The truth is there isn't much inflation in the economy. Last month's CPI came in at 3.2%, and that isn't a huge amount of inflation. Yes, gas costs more and food has gone up, but that's not all we buy. But it's what we buy consistently. So when those prices jump, we perceive that the price of everything else is skyrocketing. But it isn't.
- For instance, did you know that the price of natural gas to heat your home has actually gone down, that electricity is only up 0.6%, and clothing has gone up 0.1%?
- If you want to understand how inflation may impact your investments, don't get sidetracked by what you perceive in your daily purchasing patterns. You have to look at all the numbers.
How is that? Well, bond investors are super-sensitive to inflation issues. They know that if inflation rises it reduces the value of the future income they'll get from their bonds. Bond investors want what's called a "real rate of return" meaning an interest payment above the rate of inflation. Otherwise they're losing money.
- For instance, if you own a bond that pays 4% interest and inflation is 3%, then your purchasing power is growing by 1% a year. If inflation were 6%, then bond investors would want to buy bonds with interest payments above 6% so that they were earning a "real rate" of return. That's why bond yields tell you what the current and future expectations are for inflation.
Regardless of what the government says the CPI is, bond investors make their own decisions about how much interest they must be paid to compensate them for current inflation and for future inflation risk. And all of these investors, from all over the world, who can do their own independent research on how much inflation is out there, are saying that there isn't much current inflation or risk of it in the near future.
Now that doesn't mean the situation can't change quickly. So we could have more inflation down the line, if the facts change. But for the time being, the inflation rate is low.
Bottom line. If you want to understand inflation as an investor, don't focus on your grocery cart or gas tank; follow the bond market.
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