Inflation update

Sure seems like we've had more inflation than this in the last year. Do you think the CPI-U is missing a lot of the real inflation that is occurring in the nation?

Hi Ken - There are a LOT of people who claim the CPI-U numbers aren't accurate. On the other hand, a LOT of those people think the CPI-U measures something it isn't designed to measure. There are lots of details to consider.

For one, the I bond rate is always based on the March-September difference in the CPI-U. In the chart on this page you can see lots of inflation between November 06 and June 07 - that move is going at an annual rate of 5.8%! But November was a low, June was a high, and they're both just local stations on a line where the express train stops elsewhere.

Secondly, the CPI-U measures inflation in things that we use up - all that stuff they sell at WalMart. By design, it doesn't measure changes in asset prices - gold, stocks and so on. Inflationary bubbles occur, and pop, in the assets area. In particular, the CPI-U measures rents, not housing prices. The housing bubble's impact on the CPI-U is only through rents, which tend to rise or fall with personal income, not housing prices.

Finally, it's hard to manipulate something as transparent as the CPI-U - the raw data isn't hidden from anyone.

Tom Adams

Thanks for the info. I think people often focus more on things that have gone up in price rather than things haven't gone up or have fallen in price (like lots of stuff from Walmart).

Tom, If the CPI-U does not account for the inflation in home prices, does it also not account for the increase in property tax amounts? I calculated a couple years ago for my first home (1984-2000) that my taxes increased on average at an 11.5 % annual compound rate, while during that same time frame the interest rates on my savings account plummeted. My property taxes since 2000 have nearly doubled again and if I plot this on a graph relative to my wages and extrapolate into the future (I know it's dangerous to extrapolate, but I thought that 7 years ago too!) it appears my property taxes will exceed my wages before my expected lifespan is over! -Mike McCune

Hi Mike - interesting question. I checked what the Bureau of Labor Statistics, which complies the CPI, says about taxes.

They do include sales taxes and other taxes you pay when you buy an item (fuel taxes, cigarette taxes, and so on). They do not include income taxes.

They don't specifically say anything about property taxes, but renters don't pay property taxes. On the other hand, of course, landlords do pay property taxes, so the CPI would include property taxes to the extent that landlords change the rents they charge when their taxes change.

Tom Adams

Thanks Tom. The "disconnect" that everyone feels - that inflation is much higher than what the numbers say, I believe has to do with what I term "complexity inflation". Nominal prices of goods and services are only part of "inflation". The number of different goods and services one must consume to keep up with society is the other part of "inflation". Price indexes only measure a change in price, they do not measure a cost-of-living. I like to compare my lifestyle with my grandfather's. He got by with only an 8th grade education, kept a nice Buick in the garage, and had enough for a vacation home in the Ozarks to retire to. A simple price index only measures the difference in prices of: the 8th grade education, the Buick, and the vacation home. The price index will tell you that since computing power is getting cheaper, inflation is going down; it won't tell you that grandpa never had to buy a computer, or update it every five years, and pay for an internet connection, or that an 8th grade education by itself won't get you anything like what it once would, or, that the Buick is a better value (adjusted for inflation) than it used to be. "Complexity inflation" is all the different goods and services required just to play the game of life, and it's a lot more than it used to be! In economic terms its a barrier to entry, and I don't believe it's captured by price indexes. -Mike McCune

Hi Mike - I agree with you. To be fair, I have to point out that there are people on the other side of this argument who say - look, if the price of strawberries goes up you can substitute grapes and your cost of living doesn't change. But taking that to its logical conclusion has us living in cardboard houses and eating gravel.

So maybe the CPI is too hot, too cold, or just right. In any case, the real question here is - is the CPI something you want to tie your investments to?

If you are a conservative investor more interested in making sure you get your investment back than in making sure you earn as much as possible on your money, then in theory I bonds are for you because they protect you from inflation while other conservative investments don't.

But I bonds are tied to the CPI, and if you believe the CPI isn't accurate, then I bonds don't work for you either. But at that point you're left without any good investment choices that I know of.

Tom Adams

Tom,

It seems like there is a lot of negative talk going around about the I Bonds. As you know, I am holding mine for mortgage, vacation and education. Do I need to be looking somewhere else or should I ride the storm out? I was convinced that I Bonds where the correct choice, but now, not so sure anymore.

Hi Patrick - although it's not obvious, there's a hurricane hitting the world's financial markets right now. In the last month there have been bank runs, multi-billion-dollar investment write downs, a falling dollar, inflationary commodity prices - including both grains and oil - and a Fed attempt to save the situation with an interest rate cut. And today we have the biggest US bank failure since days of the Savings and Loan scandal.

Note that depositors are insured up to $100,000, but this bank had $109 million in deposits over the $100,000 limit. "Those customers will become creditors in NetBank's receivership, the FDIC said."

Now is the best time ever to be in a safe investment like I bonds.

Tom Adams

Tom,

Just checking to see if that hurricane is still in effect or has it been downgraded to a tropical storm? I have done some reading on it and seems like there will be some type of storm for a long time. What has to happen for this to stop and if it does, is that a good thing for us I Bond investors?

Hi Patrick - The storm just keeps getting worse. It ties back to the housing bubble, which happened because our financial wizards encouraged individual borrowers to take out loans the borrowers had no real chance of repaying. But the wizards got big fees for making the loans, so what did they care?

Now housing prices are falling, adjustable-rate loans are adjusting so that monthly payments are much higher, and these borrowers aren't able to repay their loans. The lenders are stuck with huge losses. If housing prices turn around so that the borrowers can sell (or borrow more) and repay the loans, the lenders will be saved. But there are a multitude of reasons why that is unlikely to happen.

As loan defaults continue to mount, all the big investment companies will take continuing large losses like the one Merrill Lynch booked last week. The Merrill Lynch CEO lost his job over that one, although they loved him when he was raking in those big fees the last few years.

The big investment companies like Merrill and Citibank will soon be bankrupt unless their buddies at the top levels of government can save them. One way it's done is by accounting regulations that allow the banks to value the loans at far more than the market says they're worth.

Where it will go from here is anyone's guess, but the only reasonable investment strategy right now is a flight to safety, which still means US government securities like I bonds. Your goal is just to lose less than others over the next couple of years.

The kind of inflation that the CPI measures is heating up (oil hit a new record yesterday), although you may still hear pundits talking about deflation. But they're talking about asset deflation - the value of real estate is tanking and, some suspect, stocks are soon to follow. But the CPI doesn't measure that kind of deflation, so it's of no consequence to I bonds.

Tom Adams

Hi Tom,

That 4.28% sure looks nice for the I Bond. I am thinking this is in direct reflection upon this hurricane we are going through. EE took a little bit of a hit, does this come from the storm also? As you commented before, this storm will last a while, so do you forsee the I Bond interest rate climbing over the next 12 months?

Hi Patrick - I'm a journalist, not an economist, but from my view in the cheap seats it appears inflation is going to be a real problem in the upcoming months, which means the inflation component of I bond rates will go up. Whether the fixed portion goes up in anyone's guess.

People who buy fire insurance don't expect a fire or want a fire - but they want to be covered in case there's a fire.

You should think of I bonds the same way. They are inflation insurance. But you shouldn't want inflation, because high rates of inflation can be very painful. However, if inflation occurs, I bonds protect you to the extent that the inflation is reflected in the CPI.

Tom Adams

I want to thank you for writing your book and providing the update on the changing rates for I bonds. I been telling my friends about how to protect their principal and fight inflation with the purchase of I bonds. Thanks for sending me your newsletter and keep up the good work.

rates are improving ,at least the interest side,bought my first one last night since last April

Am I correct that with the current inflation rate of 4.83%, older I-bonds with a 3.6% fixed rate will be earning a composite rate of 10.71% beginning May 1st? If so, why didn’t I buy a lot more?

Nik - you need to check your math. The 3.6% fixed rate I bonds will only pay 8.52% when they get their next inflation adjustment. For the formula, see the comments on this post.

Tom Adams

Buying one more tomorrow before the first . With inflation taking off my wife has decided that I-bonds are not a bad deal after all !