Archives For Inflation (CPI)

I was looking at the CPI numbers this morning and noticed something interesting. For some reason, the CPI puts education and communications together in the same category:

I can think of one good reason to group the two together: to hide the inflation rate of education. To see what I mean, take a look at this graphic I put together that shows the total and average annual rates of inflation for each of the categories:

Wow. Look at the three subcategories for education compared to the subcategories for communications. Then, notice the the numbers for the education and communications category as a whole. No wonder why the BLS puts these two in the same category.

The following exerpts out of Thomas Sowell’s Basic Economics come as a surprise to me because I had always assumed (from what I had read) that the CPI was understating inflation. Thomas Sowell says it differently:

At the beginning of the twentieth century, the national output of the United States did not include any airplanes, television sets, computers or nuclear power plants. At the end of that century, American national output did not include many typewriters, slide rules (once essential for engineers, before there were pocket calculators), or a host of equipment and supplies once widely used in connection with horses that formerly provided the basic transportation of many societies around the world.

What then, does it mean to say that the Gross Domestic Product was X percent larger in the year 2000 than in 1900, when it consisted of very different things? It may mean something to say that output this year was 5 percent higher or 3 percent lower than it was last year because it consists of much the same things in both years. But the longer the time span involved, the more such statistics approach meaninglessness.

A further complication in comparisons over time is that attempts to measure real income depend on statistical adjustments with a built-in inflationary bias. Money income is adjusted by taking into account the cost of living, which is measured by the cost of some collection of items commonly bought by most people. The problem with that approach is that what people buy is affected by price. When videocassette recorders were first produced, they sold for $30,000 each and were sold at luxury-oriented Neiman Marcus stores. Only many years later, after their price had fallen below $200, were videocassette recorders so widely used that they were now included in the collection of items used to determine the cost of living, as measured by the consumer price index. But all the previous years of dramatically declining prices of videocassette recorders had no effect on the statistics used to compile the consumer price index.

A little further…

While many goods that are declining in price are not counted when measuring the cost of living, common goods that are increasing in price are measured. A further inflationary bias in the consumer price index or other measures of the cost of living is that many goods which are increasing in price are also increasing in quality, so that the higher prices do not necessarily reflect inflation, as they would if the prices of the same identical goods were rising. The practical—and political—effects of these biases can be seen in such assertions as the claim that the real wages of Americans have been declining for years.

Various economists’ estimates of the upward bias of the consumer price index range about one percentage point or more. That means that when the consumer price index shows 3 percent inflation per year, it is really more like 2 percent inflation per year. That might seem like a small difference but the consequences are not small. A difference of one percentage point, over a period of 25 years, means that the average American income per person is under-estimated by almost $9,000 a year. In other words an American family of three has a real income of more than $25,000 a year higher than the official statistics on real wages would indicate. Alarms in the media and in politics about statistics showing declining real wages over time are describing a statistical artifact rather than an actual fact of life. It was during this period of “declining real wages” that the average American’s consumption has increased dramatically while the average American’s net worth more than doubled.

Interesting argument. I’m not sure I agree with Dr. Sowell on this one.

More later. I have jury duty this week.

The Bureau of Labor Statistics publishes the Consumer Price Index, which is the standard for tracking inflation. The way the CPI is calculated was altered in the early 1980s and again in the 1990s. A facebook friend of mine sent me a link to an interesting inflation chart that publishes an alternative inflation number based on the formula used prior to the alterations. As you can see from this chart (click on the chart to see a larger version), those changes had the impact of making inflation appear much lower than it would have been had the changes not been made.

According to the above chart, inflation is running at 8.50% rather than the 1.15% that the BLS is publishing. This is important because the government’s programs like Social Security base their cost of living adjustments on the CPI. So, retirees are getting a COLA for 1.15% when the actual inflation rate is 8.5%. A lower inflation number also impacts COLA adjustments for wages.

What do you think? Do you think inflation is higher than what the government is telling us?

Inflation and Your Mortgage

September 16, 2010

Mark’s comment on yesterday’s post inspired this post. Thanks, Mark!

I have written about the impact of inflation on mortgage payments in the past (see: Your Mortgage May Not Be As Expensive As You Think It Is). The problem with old posts is that they get buried and no one ever reads them again.

The companies (and certain radio and TV personalities) that talk about mortgages and how much interest you pay, aren’t telling you the full story. If you buy a house with a $200,000 mortgage with a 4.75% fixed interest rate for 30-years, they will tell you that you will pay nearly $160,000 in interest alone! In absolute dollar amounts they are correct. But, they are also very wrong because they are not factoring inflation into the equation. Why is inflation important? Well, for several reasons:

1. Inflation usually means that prices will go up over time.

2. Inflation can lead to cost-of-living adjustments (increases) to wages.

3. Meanwhile, the amount you pay on your fixed mortgage stays the same.

What this means is that your payment—although it stays the same dollar amount throughout the mortgage term—it decreases over time due to inflation.

How much?

Of course it depends on the inflation rate. The higher the inflation rate, the cheaper your fixed mortgage becomes over the years. For instance, check out the following four graphics I put together. The first two represent a 30-year mortgage. The first one is with a 3% inflation rate and the second one is with a 4% inflation rate. Notice the difference between the total amount of interest paid and the total amount of interest paid NET inflation. Pretty sizeable difference.

30-Year Fixed Mortgage with 3% inflation

30-Year Fixed Mortgage with 3% inflation

30-Year Fixed Mortgage with 4% inflation

30-Year Fixed Mortgage with 4% inflation

For those interested in 15-year mortages, I ran those numbers too:

15-Year Fixed Mortgage with 3% Inflation

15-Year Fixed Mortgage with 3% Inflation

15-Year Fixed Mortgage with 4% inflation

15-Year Fixed Mortgage with 4% inflation

How did I arrive at these numbers? I did what’s called a discounted cash flow of the mortgage amortization. This is where you take each payment and discount it at the expected inflation rate. You can read Your Mortgage May Not Be As Expensive As You Think It Is to get the math.

What can we take away from this? Well, for one, with interest rates on mortgages as low as they are right now and inflation expected to rise in the future, you might be better off keeping with a long mortgage. The higher the inflation rate, the cheaper borrowed money becomes (as long as you have a good interest rate on the loan).

Those who adamantly suggest that people pay off their mortgages as quickly as possible are missing the big picture.

Check out this graphic I put together using the information I found on

During the first decade of the 21st Century, the price of gold has seen an average annual increase of 14.41% compared to the S&P 500 Index’s Total Return of -.95%. For those who are interested, I put together a History of Gold Prices 2000 – 2009.

This is not to be taken as a promotional for investing in gold. I think gold can drop in value just as much as any other asset. And, since I see 3 or 4 gold commercials every 30 minutes on the news networks, it makes me think a bubble may be forming. Who knows. I sure don’t.

In his book, The Little Book of Bull Moves* (highly recommended), Peter Schiff recommends using gold as gauge for inflation:

“The concept of inflation remains fairly elusive: Since the real rate can’t be quantified, we have to compare changes in nominal prices to price changes in a commodity, such as gold, which is a better store of value and therfore a more objective standard by which to measure prices. Ratios representing these price relationships have historically guided us in judging how much inflation is reflected in nominal prices.”

He even mentions that he thinks inflation has run closer to 8 – 10 percent per year rather than the 4 percent the government has been publishing via the CPI. Interesting…

*Affiliate Link

Okay, for those you who like graphics (do any of you like graphics or am I just doing this for my own gratification?), here is a decade-by-decade look at the S&P 500 Total Return Index and the CPI.

I began each decade with the S&P 500 TR Index, the CPI, and the S&P 500 TR Index Real Return (minus the CPI), all indexed at 100. I then used monthly returns to perform the calculations. To get the real return for the S&P, I simply took each month’s return for the index and subtracted the CPI.

Table - S&P TR, S&P TR RR, and CPI (1960 - 1969)

The decade of the 70s saw the CPI compound at 7.33% per year while the S&P only returned 5.96% per year. Hard to build wealth that way.

Table - S&P TR, S&P TR RR, and CPI (1970 - 1979)

Table - S&P TR, S&P TR RR, and CPI (1980 - 1989)

Table - S&P TR, S&P TR RR, and CPI (1990 - 1999)

As bad as the 70s were, the first decade of the 2000s was worse. While the CPI was compounding at reasonable 2.56% per year, the S&P was losing .95% per year. Just think…those numbers even INCLUDE 2009’s stellar performance!

Table - S&P TR, S&P TR RR, and CPI (2000 - 2009)

Bottom line: Inflation matters. Even small inflation numbers can have a significant impact on long-term returns and purchasing power.

Taking a look at the S&P 500 Index adjusted for inflation.

After putting together last week’s posts comparing the S&P 500 Index with the Unemployment Rate, I decided to take a look at the S&P 500 Total Return Index along with the Consumer Price Index from 1960 through 2009.

Here’s the S&P 500 TR Index from 1960 – 2009:

NOTE: When putting these graphics together, I indexed the S&P 500 Index and began with a value of 100 in 1960.

S&P TR Index (1960 - 2009)

Not too bad, huh? Sure it was pretty volatile over the years but for the most part it had an awesome run.

Now, here’s the same index adjusted for the CPI:

NOTE: This graph was also indexed to begin with a base rate of 100 in 1960. To compute the returns, I took the total return for the S&P 500 Index and subtracted the CPI for that month.

S&P TR Index (1960 - 2009) minus CPI

Again, it doesn’t look too bad. It looks just like the previous chart, does it?

Now, here’s where it gets interesting…

Here’s what you get when you combine the two charts into one:

S&P TR Index & S&P TR Index minus Inflation

Pretty dramatic difference, isn’t it?

On an indexed basis, the ending value in 2009 of the S&P 500 TR Index (with a starting value of 100 at the beginning of 1960) was 9191.65. When you adjust that for inflation, the ending value is 1245.41. In other words, inflation ate up over 86% of the S&P 500’s return [1 – (1245.41 &#247 9191.65) = .8645 or 86.45%].

From 1960 through 2009, the S&P 500 TR Index compounded at 9.46% per year. The CPI compounded at 4.06% per year. The S&P 500 TR Index adjusted for inflation compounded at 5.17% per year. Inflation makes a huge difference.