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The Inflation Conspiracy

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.
You can go to the Department of Labor website and read about the different inflation categories. Now I know these categories don't reflect exactly what you might buy, but they do reflect what we buy as a society in general. And while you could quibble with the formulas, it doesn't really matter, because the bond market is telling you that there currently is very little inflation and little worry about big inflation any time on the horizon.

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.
Look at the bond market today. Rates for high-quality 10 year bonds have been hovering around 3.75%, meaning investors think a 3.75% interest payment will compensate them at a rate above inflation for the next 10 years. In fact, interest rates have fallen over the past few weeks, indicating that the inflation pressures may be even less. And the price of oil, after peaking recently, is falling again. You should start to see that at the pump any day now.

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.

Learn More: Want to learn about a simple way to manage your personal finances and prepare for retirement, investigate my new book Your Money Ratios: 8 Simple Tools For Financial Security, available in bookstores and at The Wall Street Journal called the book "one of the best finance books to cross our desks this year." WSJ 12/19/09.

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