All Things Financial Planning Blog

Should You Be Worried About Inflation?

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A recent article in the Wall Street Journal (Why You Can’t Trust the Inflation Numbers, by Bret Arends) caught my eye. The author suggests that the most recent (low) inflation numbers published by the US government are lulling us into a false sense of security. He makes three assertions:

  • The government’s inflation numbers are not to be trusted.
  • Published inflation figures tell us what inflation was, not what inflation will be.
  • The enormous growth in the US money supply must inevitably produce inflation.

You hear the first argument a lot. As a former economist, I tend not to agree. The professional economists who work on inflation, both in the US government at the Bureau of Labor Statistics (BLS) and in academia, are a pretty careful, serious lot. They have designed (and updated) the Consumer Price Index (CPI) to measure changes in the purchasing power of the dollar.

At least two things about the CPI are useful to bear in mind:

  1. It is an index. It attempts to capture a change in average prices, not any single price. Thus, you may notice that one or several prices that are important to you may go up a lot, but the CPI doesn’t budge. That doesn’t necessarily indicate that the CPI is wrong. If other prices have gone down, average prices may not have changed. For example, if gasoline prices go up, but housing prices go down, the purchasing power of the dollar may not have changed. You can buy less gas for a dollar, but you can buy more house (and, because you don’t buy houses that frequently, you may not notice that you can buy more house).
  2. The CPI adjusts for quality. Mr. Arends points out that the cheapest Mac laptop costs the same today ($999) as it did several years ago. Yet, because the new Mac laptop offers more computing power, the CPI says that the price has fallen. Mr. Arends is scornful – just try to ask for a discount on that Mac laptop, he says. However, he misses the point that you can buy a laptop comparable to the old Mac laptop today (perhaps from Dell), and you can buy it for less. Apple has disguised falling computing power prices by incorporating more computing power in its new laptops for the same laptop price. Nevertheless, the price of computing power has fallen.

It is true that the CPI tells us what has happened. It is not a forecast. It is also true that inflation as measured by the CPI has been low for the last three years, at .1% for 2008, 2.7% for 2009 and 1.5% for 2010, for an average of about 1.4% per year.

Now, what about the money supply? The Federal Reserve purchased large quantities of bonds over the last three years, and it “printed” lots of money to do so. You may have seen a chart (the link will help you access several) showing that the Federal Reserve’s assets and liabilities have both grown dramatically (more than double) since the beginning of the financial crisis.

This is definitely a cause for concern about future inflation. As a budding economist, I learned that increases in the money supply cause inflation. However, as with almost everything, the world of monetary economics is more complex than we learn in school. The particular complexity in this case is this: the money that the Federal Reserve “printed” to buy Treasury and other bond assets on its balance sheet is largely being held by banks as deposits at the Federal Reserve. In other words, the banks sold bonds to the Federal Reserve, and kept the cash. So long as the cash doesn’t get into the economy, there isn’t more cash chasing the same amount of goods and services, and therefore, no additional inflation.

Now, to get out of this situation without a lot of inflation, the Federal Reserve has to manage the situation skillfully. In effect, just as the banks decide they want to lend some of that extra cash, the Federal Reserve has to persuade them that they should use the cash to buy bonds instead. The Federal Reserve may or may not be able to do that. But future high inflation is not guaranteed.

So, should you be worried about future inflation? I’d say “don’t worry, but do pay attention.”

  • The US government is not “cooking the books” to underestimate inflation – there’s no conspiracy to hide inflation from the citizenry.
  • The CPI did not change from April to December of 2010 – no inflation, let alone a hint of accelerating inflation. Rapid month-to-month rises in the coming months would indicate that inflation is speeding up.
  • Do watch (or ask your financial adviser to watch) for indications that the banks are lending money faster than the Federal Reserve can soak it up with asset sales.

Finally, even if you are not worried, it is wise to protect your financial assets from future inflation – TIPS (Treasury Inflation Protected Securities) are the best inflation hedge available.

rickMillerRick Miller, CFP®
Sensible Financial Planning & Management
Cambridge, MA

Author: Rick Miller, CFP®

Rick Miller founded Sensible Financial Planning and Management in 2002. Sensible Financial helps clients plan for and reach their life goals from a solid financial foundation. Its services are especially attractive to people who haven’t been comfortable using a financial advisor or who thought they couldn’t afford one. The firm uses analytically rigorous techniques to develop its personalized advice and offers access to the most efficient and effective financial products and services. In its investment management practice, Sensible Financial uses index funds and ETFs almost exclusively. Financial Advisor magazine ranked Sensible Financial as one of the fastest growing registered independent advisory (RIA) firms in both 2005 and 2006. Assets under management now exceed $170 million. Mr. Miller has worked in financial services for over twenty years, first as a management consultant, then in product and business development at Scudder Investments, and now at Sensible Financial. He holds AB, AM and Ph.D. degrees in Economics from the University of Chicago. He is a CFP Certificant, and a member of both NAPFA, the National Association of Personal Financial Advisors, and the Financial Planning Association. In 2008, he served on the FPA Massachusetts Chapter Board. He recently served on both the Trends in Financial Planning and Job Analysis Task Forces of the CFP Board. He has been quoted in the Boston Globe,, NPR’s Nightly Business Report, and other local and national media.

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