The Spectre of Inflation – Part I

For the last week or so I’ve been a bit of dog with a bone about inflation. It comes up in every retirement calculator and I started wondering how much of a concern this really is in retirement spending. Is inflation a real concern or just a spectre of fear that the investment industry uses to get you to save more?

Since this topic ended up growing a bit more than I had first planed on I’ve had to break it up into a couple of posts. Today we will start off with a little education session for those not familiar with inflation. Inflation is the measured with the Consumer Price Index (CPI) which consists of a basket of good which the government tracks on a monthly basis to track the tendency of prices to increase over a long period of time. In Canada, the data comes from Statistics Canada, but the Bank of Canada is the one using the data to determine if inflation is being controlled within their set target range which is currently 1 to 3% over an entire year.

Since the CPI consists of several volatile components (like fruit, veggies, gas and heating oil) the Bank of Canada likes to strip those out to get a better idea of the core inflation. The core CPI consists of 84% of those items in the total CPI. This core rate is used as a operational guide to ensure the bank is keeping inflation with in their target. For example the core rate of inflation was measured at 2.0% in December 2006, while the total CPI was 1.6% (see here for more data).

Now in general the CPI is useful since Canada Pension Plan (CPP) and Old Age Security (OAS) benefits are adjusted to reflect changes in the CPI rate. Yet despite it’s almost universal acceptance of the measure of inflation in Canada, it does have some problems when using it for personal calculations such as retirement estimates.

The CPI’s basket of good goods is based on the national average of a an urban Canadian’s spending habits. The spending habit data is only updated every four years, which means the CPI’s basket of goods lags the current average Canadian’s spending habits by up to five years (four year between gather data and 1 extra year to process it). Another problem of using the average Canadian is it tends to skew the spending to those in the upper middle class, since their larger incomes tend to shift the average spending up. Another problem with the CPI’s basket is it only uses urban data, which means it doesn’t reflect any rural spending habits. Also using a national number doesn’t reflect your regions inflation particular issues. For example, Alberta’s inflation is significantly higher than Nova Scotia’s due to current regional economic conditions.

All of these issue contribute to the bias of the CPI and on average it is estimated it is 0.5% higher than real inflation. Which means if your using a calculator with a 3.0% inflation rate, your overshooting the average by at least 0.5% a year. Tomorrow we will look at some more data to try and come up with a better inflation number.

9 thoughts on “The Spectre of Inflation – Part I”

  1. One thing to always bear in mind with inflation measures is that they always measure a “fixed” basket of goods. If you’re an average consumer, you don’t always buy the exact same things every month. If apples are particularly expensive one week, and other fruits are cheaper, you’ll probably skip apples for a week and get the cheaper option.

    There are plenty of other ways that individual spenders can insulate themselves from inflationary pressures.

    I keep inflation in the back of my mind when dealing with retirement planning, but I think it’s mostly utilized by investment “advisors” to scare people into saving for retirement.

  2. George,

    Well said, actually very similar to what I was going to say in part of Friday’s post.

    It’s good to hear I’m not the only one thinking about these things.

    CD

  3. George and CD,

    I agree that consumers will substitute cheaper items when the costs of the original item goes up, but I don’t think that we should be careful about adjusting our measures this way. Why? Because CPI should be a measure of the cost to keep your standard of living.

    Say for example that steak was part of the CPI calculation, but steak goes up in price and then you decide to substitute hamburger. Well, yes, your costs go down, but so does your standard of living. You could eventually substitute for meat scraps and dog food to eat for cheaper. I think that CPI should remain an absolute measure of whether cost are going up or down.

    How would you feel if you went to your boss and asked for a raise and he came back to you and said, “Eat potatoes instead of bread because they are cheaper and you’ll end up with a lower cost of living”. Okay, I exaggerate, but you get the point, right?

    As for the core rate. That is one of the biggest pieces of political BS. Core rate was never intended to be used as a measure of inflation like it is today. It was to try to reduce/measure the volitity of the CPI measurment.

  4. Although I do agree with george and CD that it’s possible to be somewhat sheltered from the effects of inflation I think that anyone considering retirement (but especially those considering early retirement) should not ignore inflation. Although you might not feel the full percentage effect that CPI indicates I believe that as an investor aspiring for early retirement it would be prudent to use the CPI as a guide or benchmark when making predictions of future cash requirements. Nobody can predict the inflation rates of the future but for those of us who plan to be retired for 40+ years no amount of substituting or cutting back is going to insulate us from some percentage of real daily inflation in our lives. I don’t think that I’ll feel the full percent effect of CPI but I’m going to use it as a safety cushion……just in case.

    Cheers,
    MCM,
    http://middleclassmillionaire.blogspot.com/

  5. Interesting comments on a topic that I don’t recall seeing being discussed very much on financial blogs.
    Personally I use 3% in my estimations – why? I don’t know, that’s just what I do along with 7% for investment returns. One of the things I’m planning to do with my retirement plans is to try to analyse what my basic living costs are each year (ie enuf to pay bills, food etc but not including eating out, holidays etc) and maybe I can see if that tells me what my personal inflation rate is?

    I tend not to worry too much about these kind of assumptions because the way I look at it, all the assumptions I’m making from now to retirement age will all have been realized by the time I retire and if necessary I can retire later or earlier than planned. During retirement as each year passes you can keep reviewing the plan and make adjustments as necessary.

  6. I agree with most of what has been said above. My point isn’t that we should ignore inflation entirely – it’s simply that you have to interpret the CPI carefully.

    Many people look at the CPI and simply think that the cost of the goods that they purchase will go up by that percentage, which obviously isn’t the case (unless they buy the exact same goods that are included in the CPI).

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