Average Trickery

According to 2005 Census data, the average US family has 3.18 persons. Naturally, we know it's impossible for any family to have a fractional population (unless Dr. Moreau's practicing without our knowledge). No one's experience is truly "average," so why would anyone look to a measure of average prices to tell them anything about their situation? And yet, it's a common mistake among investors. They frequently misunderstand the term "inflation," how it's measured, what it means, and its implications.

Most associate inflation with the Consumer Price Index (CPI) produced by the Bureau of Labor Statistics, and for good reason. It's probably the most comprehensive measure of prices we have today. The CPI measures the average price of a basket of goods and services produced, whether you buy them or not—over 80,000 goods and services to be exact. We're just guessing, but you probably don't buy all of those things. Not in a single year, at least.

Not everyone drinks Zima, eats at Olive Garden, attends Red Sox Games, or pays for their children's University of Miami education. That is: The aggregate disguises the variability of individual components and does not discriminate based on your specific spending habits. Simply, folks presume inflation translates directly into their cost of living, but it doesn't. For instance, if you have three sons in college, you probably think inflation is through the roof—the cost of education has risen nearly 75% over the past ten years. Yet, inflation, as defined by CPI, was just over a third of that over the same period—your cost of living was quite different than inflation. Some good news? Apparel has fallen 10% over the same period. It may be of little consolation, but at least you're not literally losing the shirt off your back.

As if matters weren't muddled enough, one must be skeptical of inflation statistics. Rarely are government statistics the best measure of reality. CPI data are released a month after the fact, making it difficult to tell what inflation is doing right now. The data are also based on sampling and cannot, by definition, provide a truly precise assessment. The "official" data are misleading, at best. A better indicator would be something measuring the value of money across the world—something market-based. Markets are significantly more telling than governmental indicators —pricing in all new information nearly instantaneously.

Long-term interest rates are, in essence, the cost of renting money, and money rental is very sensitive to the ravages of accelerating inflation. Lenders want to be paid for higher inflation through higher interest rates; consequently, if inflation is becoming a problem, it should be reflected in long-term interest rates. That global long-term interest rates have been benign for the past several years tells you inflation isn't a worry.

Another reason not to fret inflation much right now? Inflation, as the late, great economist Milton Friedman said, "is always and everywhere a monetary phenomenon." Central banks control monetary policy—if they create excess liquidity beyond what the economy can absorb, price levels increase. Central bank policy, therefore, plays an important role in economic stability—it must find an appropriate balance of adjusting monetary policy enough to contain inflation expectations without strangling economic growth. For those remembering the 1970s, that probably doesn't instill much confidence. But today's central bankers have access to vastly more data than their predecessors, and the benefit of learning from past central banking mistakes. They can now test their theories before instituting them to disastrous results. Are central banking errors still made? Sure, but the risk of massive policy errors has decreased significantly, and the market knows it

Don't be tricked by inflation figures in the popular press. Those averages just won't tell you much and are best left to the central bankers. The sticker shock over your children's college education, however, is another matter.