Is Inflation Imminent?

Unexpected inflation can have a huge impact on one’s finances, so it is important that we always forecast it.  Therefore, will inflation accelerate from the present low level, or will it stay low?

With record low interest rates in the US, and with unemployment still high, Federal Reserve Chairman, Ben Bernanke, believes that inflation is not a threat.  Do you trust his assessment? 

I have been around long enough to be cynical and/or mistrustful of what our leaders tell us.  So, let’s decide for ourselves whether or not inflation will increase significantly.  First I’ll place my bets, and then you can place yours.  If you conclude inflation will accelerate, what steps will you take to profit from, or at least not be hurt by it?  If you conclude it is not approaching, you may decide you are fine without making any changes to your current financial situation.

Let’s start by reviewing each of the eight major components of the CPI index.  I will then place my bet as to whether their prices will increase more than in the recent past.  Food and beverages make up 15% of the index.  With commodities prices such as sugar, corn, soybeans, wheat, milk, coffee, and cocoa hitting, in some cases, record highs, I am certain this part of the CPI will see a huge increase.  Housing and utilities comprise 43% of the inflation measure, and indications are that rental vacancies are dropping, so rents may start increasing again.  We also know that water and electricity rates are rising.  On the other hand, housing prices may continue to drop, so I’m betting that the housing segment of the index will not increase by much.  Apparel and upkeep represents 4% of the index, and cotton prices have nearly doubled in the last year, so expect to see inflation in apparel prices.  Furthermore, the dollar has dropped versus the Chinese currency, so it is natural to expect an even greater increase in apparel prices, given that so many of our clothes come from China.
Transportation is 18% of the CPI index, and we all know what is happening to gas prices.  Car prices may also increase a bit, so I will bet that transportation costs go up.

Medical care is 6% of the index, and you can expect this area of inflation to skyrocket. For example, my dentist told me the other day that he no longer accepts insurance.  Either I pay him what he wants, or I should go find another dentist, he said.  So, I expect accelerated inflation in medical care.  Recreation represents 6% of the CPI index, and I’m assuming this won’t rise.  Education is 6%, and with all the cuts to education, you can be sure this will increase markedly.  Somebody has got to pay for education.  “Other” is 3% of the index, and I’m assuming this won’t increase.

Let’s tally.  Here’s what I am betting will go up significantly more than in the last few years: food (15% of the index), apparel (4%), transportation (17%), medical care (6%), and education (6%). This represents 54% of the total inflation index.  Here’s what I believe will stay flat: housing (43%),  recreation (6%), and other (3%).
In sum, I am confident that 54% of the CPI index will see a major increase, while the other 46% will remain flat. Thus, it seems we cannot believe Mr. Bernanke’s assertion that inflation is not imminent.  But don’t take my word either. Do the same analysis I did, and then add up your tally. Will your prediction reflect Bernanke’s view or my more pessimistic one?

Interestingly, if inflation is not an accelerating phenomenon, why did gold and silver hit new highs?  Why did China and the Europeans raise interest rates in the past few days?  They claim it was to cool inflation.  Bloomberg news also reported on Thursday that “the Journal of Commerce-ECRI Commodity Price Index reached the highest since at least 1985 . . . This index tracks 18 commodities, including burlap, tallow, plywood and steel”, so it is also pointing towards higher inflation.

If my bet that inflation will accelerate is correct, how can this affect a typical investor?  Who will lose and who will gain? Inflation causes a massive transfer of wealth from creditors to debtors.  Why?  Assume you invest $100,000 today in a ten year bond, and that a cup of coffee at Starbucks costs $2 now. In other words, your money will buy 50,000 cups of coffee, to use a generic example.  Let’s assume that inflation accelerates to an average rate of 3% per year.  In ten years, when your bond matures, a cup of coffee will cost $2.70.  When your bond matures, you’ll get your $100,000 back but that money will only buy 37,000 cups of coffee.  Inflation caused you to lose the equivalent of 13,000 cups of coffee or nearly 26% of your $100,000.  In other words, don’t think money . . . don’t think principal . . . don’t think nominal values . . . think PURCHASING POWER.  You never want to maintain capital; you always want to maintain the purchasing power of your money. 

In the example I just reviewed, the creditor (the one who bought the bond) lost big.  Who won?  The guy who borrowed the money from you via the bond.  He borrowed $100,000 which could buy 50,000 cups of coffee, but he only returned the equivalent of 37,000 cups.  He, the debtor, won and the creditor lost.

In sum, I am predicting that inflation will accelerate.  You won’t want to lose money if this happens.  Learn how to protect yourself.  Call me at 714-771-6000. And by the way . . . If you have a friend who is about to retire and wants to maintain his/her lifestyle and financial security throughout retirement, ask them to call me.  I can help.