The US government is trying to tell you that inflation is extremely low and not a threat, but that’s disingenuous.

Granted, there are lots of economists out there who tell us that if you look at today’s price of goods and services on an inflation-adjusted basis, we’re really not paying much more for things than we were decades ago.

I recently came across an article that mathematically proved—and the math checked out—that when adjusted for inflation, gasoline today costs about the same as it did in the 1960s. The only real spikes occurred during the energy crisis of the 1970s and in times of war when rationing was in effect. As a result, the argument goes, we don’t really spend more on gasoline now than we ever have.

The problem with that proportional spending assertion is that US wage growth has failed to keep pace with even the meager rate of inflation. The graph below shows that trend just since the beginning of 2012 but, if you stretch that data out, you’ll see the same trend in place going back to 2007.



Consequently, if you’re not concerned about inflation today, you should be because you’re losing spending power. And it’ll only get worse.

Perfect Storm

So why is inflation so high today, despite the fact that the global economy is still growing relatively slowly? To put it succinctly: the US government is the main culprit.

Since the financial crisis of 2008-2009, the US government has taken an extremely accommodative monetary policy, unleashing billions of dollars in federal spending to stimulate job creation through programs such as transportation spending. It has also provided tax breaks to boost the incomes of those who were still working, hoping to stimulate spending.

On the monetary side of the equation, the US Federal Reserve has been running a zero-interest policy rate (ZIRP) to keep credit cheap and hopefully spur loan growth. On top of that, the Fed is now in its third round of quantitative easing (QE), by which it purchases Treasury bonds, mortgage-backed securities or other financial assets in the market, adding additional liquidity to our nation’s money pool.

While there isn’t a perfect dollar-for-dollar correlation between the level of assets currently held on the Fed’s balance sheet and the amount of money actually in circulation, the size of the Fed’s balance sheet is a good approximation for how much nominal money is out there (see below).



Under normal conditions, low interest rates, money printing and recessions are bearish for currencies. As you can see in the graph below, between 2001 and when the financial crisis began in earnest in 2008, the dollar had been in pronounced secular decline, largely due to relatively low rates and hiccups in economic growth as measured by the US Dollar Index. The index compares the value of the dollar against a basket of international currencies.



The recession caused by the Dot Com implosion in the early 2000s was exacerbated by 9/11 and the string of terrorist attacks around the world. In response, the Fed crash-dived interest rates from 6.5 percent in mid-2001 to just 0.75 percent by January 2002. As a result, the dollar fell victim to what amounted to a “carry trade,” as traders borrowed in cheap dollars to buy other international assets.

Not incidentally, there’s a clear cause-and-effect link between a weak dollar and a spike in inflation, as shown by the graph below.



Most global commodities are priced in US dollars, so when the dollar is strong we get a bigger bang for our buck when we purchase anything grown, dug or pumped out of the ground. When the dollar is weak but global demand for commodities is still strong, we have to pay more in dollar terms for those same commodities. That makes a weak dollar a major driver of American inflation.

The correlation between the dollar and inflation has lessened somewhat over the past few years. The dollar, mainly in the form of Treasuries, has become the safe haven asset for both investors and governments around world.

Therefore, the dollar has remained extremely resilient since 2008, even though existing fundamentals such as high government debt, low interest rates and aggressive easing have argued against a strong dollar. However, I look for that correlation to return to its historical norm over the next few years, as the global economy continues to return to health.

The major danger here is that the Fed will be slow in stepping back its asset purchases and bumping up interest rates. That very hesitancy was a major driver of the weak dollar, which helped generate the sharp uptick in inflation we experienced between 2006 and 2008. Cheap money also helped inflate the real estate bubble, which was a root cause of the Great Recession.

Given that the Fed has an extremely poor track record for timing its moves, smart investors should bet on it blinking this time as well.

Whenever Fed Chairman Ben Bernanke even so much as hints at the end of QE, the markets react violently to the downside and no one ever wants to rock the boat on a rising bull tide. At the same time, our gross domestic product (GDP) growth has remained tepid, unemployment has been falling but remains stubbornly high and the government says that inflation is nearly nonexistent.

That’s not exactly a set of circumstances that calls for withdrawing support. No one in Washington wants to bear the blame for derailing the American economy. However, growth is largely a lagging indicator so, by the time it’s where you want it, it’s already too late to dodge an inflationary bubble.

Even more significantly, the US isn’t the only country that’s been aggressively stimulating its economy. Central banks the world over such as the Bank of Japan are running ZIRPs and easing programs all their own, resulting in even more liquidity chasing the same goods and services.

Lies, Damn Lies and Statistics

Let’s start with the Consumer Price Index (CPI), our nation’s official measure of inflation which has been in existence for nearly a century.

The CPI was first created during World War I, to help the government set pay levels for war workers, ensuring wages were high enough to lure laborers out of fields and workshops and into armament factories. It was also used to ensure wages rose fast enough to keep up with rising wartime costs, keeping workers in those factories to churn out everything our troops needed.

The CPI was originally designed as a cost of goods index (COGI) and measured the cost of a fixed basket of goods such as food, energy, clothing, housing and a host of other items across both time and geographies to create historical data that was roughly representative of price changes nationwide.

The US Bureau of Labor Statistics (BLS), part of the Department of Labor, largely stuck to that COGI methodology for decades, although there were some changes along the way. Just as the Dow Jones Industrial Average has evolved over time to reflect the changing face of American business, the BLS has updated the CPI over the years to reflect evolving consumer tastes and needs.

But after the stagflation of the 1970s, the BLS radically redesigned the CPI, transforming it into a cost of living index in the early 1980s that essentially measures the cost of maintaining a rather meager standard of living.

One of the biggest changes that the BLS implemented was “substitution.” Under this methodology, for example, sirloin steak is swapped out for hamburger, as the rising cost of steak prompts consumers to buy the cheaper alternative. Another change: “quality adjustments,” which count something at a lower cost if the quality improves, even if the price hasn’t changed.

Owner’s equivalent rent was also introduced around that period. Rather than measuring market rate rents across the country, the BLS uses a hybrid approach that attempts to measure “the flow of shelter services for an owned dwelling from items related to living in it,” while considering the dwelling itself an asset rather than a liability.

The problem with that approach is that very few people buy their homes free and clear. The average homeowner typically takes out a 30-year mortgage and then bears all upkeep costs, which usually amount to a substantial sum of money, paid out a month at a time. And just like everything else, the cost of a new roof or a plumber’s or electrician’s fee is hardly static.

As you can see from the graph below, those changes resulted in a radical decline in the US inflation rate, at least on paper.



The blue line shows the official government reading of US inflation, while the red line shows what the inflation rate would be if the methodology prior to 1980 were still in use. As you can see, in January 1982 a radical divergence emerged between the two data sets that creates a serious credibility gap for the government.

But why would the government want to understate inflation?

For one thing, America was just emerging from the stagflationary 1970s, the recession caused when Paul Volker broke the back of inflation. Monetary and fiscal authorities were taking a more accommodative stance and there was some concern within the circle of policy makers that inflation could rear its ugly head again. The easiest solution? Simply change the way inflation is measured.

It was also around this time that some economists and statisticians started raising questions about the sustainability of the Social Security Trust Fund.

Many politicians today would like us to believe that worry over the impact of a wave of retirees on our nation’s social safety net is new, but this concern has been around for decades. Since increases in Social Security payments are directly tied to increases in the CPI, redesigning the index to show a lower inflation rate literally saves the government billions of dollars in benefit increases each year.

By keeping inflation ticking the government is basically repaying its old debts in cheap dollars, reducing the real cost of its debt service. Reporting lower inflation also makes GDP growth look much stronger than it actually is.

The government’s measure of GDP growth aims to measure “new” activity in the economy and doesn’t want to capture the impact of consumers paying higher prices for the same things. To do that, it uses what is known as the personal consumption expenditures deflator to back the impact of inflation out of GDP growth and the CPI is a major component of that.

By underreporting inflation in the form of the CPI, the government makes American economic growth look stronger than it actually is.

Fight Back!

Forces are in place to keep driving inflation higher in the coming years, but Washington has every incentive to keep telling us that it’s actually quite low. However, we’re lucky to have at our disposal the necessary tools to fight back, even if we can’t force the government to be more transparent on the issue.

I delve into the nature of these tools and how you can wield them, in this issue’s Survival Spotlight and Portfolio Update articles. I’ll also focus on them in future issues.

These tools boil down to five basic investment choices and tenets: commodities, foreign stocks, currencies, high yields, and value investing.

Each plays a significant role in protecting the value of your portfolio, by providing exposure to both the root causes of inflation and its symptoms. I will incorporate these elements into our two portfolios, Survive and Thrive.

I’ll keep you updated on the true state of inflation in the US, in our publication’s Inflation Gauge graphic that I’ll update each month.

You’ll also receive our weekly e-letter, Survival of the Fittest, which will keep you updated on our inflationary take between issues of The Inflation Survival Letter and provide you updates on our portfolio holdings.

I look forward to helping you win the battle for inflation survival.