Putting a Perspective on Inflation

The term “inflation” figures importantly in discussions of finance and investment. But many kinds of numbers may be bandied about, and they don’t all mean the same thing. Here’s an overview of the principle measures of inflation:

  • The Consumer Price Index (CPI) measures the changes in price for fixed baskets of common consumer goods and is intended to show how changing prices impact consumer spending power from month to month.

The CPI assumes that the consumer would be buying the same quantities of identical goods each month. As a result, the CPI does not fully capture the impact of structural changes on individual buying behavior, such as purchasing a more fuel-efficient car in response to a spike in energy prices. Many consumers use changes in spending patterns to free up resources and lessen the impact of inflation on other priorities.

The CPI also assumes that each price change hits every consumer equally. However, some consumers may bear the brunt of some price changes disproportionately. For example, a sharp change in home prices would not have any immediate effect on most homeowners’ actual monthly spending priorities even though the change would impact reported CPI.

  • The GDP Implicit Price Deflator shows how changes in price levels impact the economy from quarter to quarter. It was developed by economists who wanted to see how much of any given change in GDP represented real growth in output, and how much was simply the result of changes in prices.

The deflator uses price comparisons for every element included in GDP and weights those comparisons according to the item’s weight in the latest economic snapshot. As a result, the deflator is instantly responsive to shifts in economic patterns, affording increased influence over the inflation tally to growing sectors and decreased influence to contracting sectors.

  • The Chained CPI is the newest inflation benchmark, existing in its current form for little more than a decade, compared with the century’s worth of history in the original CPI. Where the original relies on inflexible formulas and rigid weighting, the chained CPI is meant to capture the effects of consumer substitutions. For the years when the chained CPI has been calculated side by side with the original CPI, the chained CPI has generally shown lower inflation. Economists debate which metric better captures consumer experience.

Measured across the grand sweep of the economy’s ups and downs, average inflation has appeared moderate. Over the long term, there appears to be little practical distinction between measurements produced by the CPI and the GDP deflator. But narrow the focus and important distinctions can appear. For example, during crushing price volatility sparked by the OPEC oil price shocks, there were potentially significant differences in the amounts of inflation recorded by each of the metrics.

Annualized Inflation for Selected Time Periods by Three Different Metrics1

1947-2013(The post-
war era)
1974-1980(The oil
price shocks)
2009-2013(The past five years)
Headline measure:
The Consumer Price Index
3.63% 9.15% 2.05%
Alternative measure:
GDP Implicit Price Deflator
3.25% 7.59% 1.39%
Net difference (0.38%) (1.56%) (0.66%)

Inflation assessments are embedded in many financial decisions. In retirement planning, underestimating inflation can leave you short of income later in life; overestimating it can lead to unnecessary sacrifice. In the context of evaluating a potential investment, a proper assessment of inflation potential can help determine whether the proposed investment could compensate for the loss of purchasing power as well as the risk you’ve assumed.

Understanding inflation trends can be a key to financial and investing success. Using metrics properly is an essential part of that understanding. If you would like to discuss how inflation affects your financial strategies, please call me.

Source: 1Bureau of Labor Statistics (Consumer Price Index); Bureau of Economic Analysis (GDP Implicit Price Deflator).

The U.S> CPI Index is a measure of the average change in prices over time in a fixed market basket of goods and services.  The index is for all U.S. Urban Consumers, which covers approximately 80% of the non-institutionalized civilian population.  This index is seasonally adjusted.  Seasonal adjustment removes the effects of events that follow a more or less regular pattern each year.  These adjustments make it easier to observe the cyclical and other non-seasonal movements in a data series.  Due to availability this is an estimated return until the 15th business day of each month, which is then revised to the finalized return.


Ivie P. Burns, II 
Senior Vice President
Financial Advisor

www.morganstanleyfa.com/burnsbinkley

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