Tuesday, September 1, 2009

Inflation,The Federal Reserve and The Consumer Price Index

Inflation Myths,The Federal Reserve,The Consumer Price Index 1913-2000, and How to Profit From Renewed Inflation




Click on Image to Enlarge

Above is a graph that I used in consultation with a client a few months ago to aid in our discussions concerning the safety [or not] of their then long-term savings plan. The graph shows the change in the US Consumer Price Index [C.P.I.] since the inception of the Federal Reserve system in 1913, through the year 2000.*

For the purposes of this graph, the C.P.I. changes were calculated using year 2000 value U.S.$'s . **


Introduction

As a financial safety consultant, my job is most often more psychology than anything else, involving as it does the close examination of a clients beliefs about investing, saving, economic principles etc. etc., and seeing if, for that person, their beliefs and previously unquestioned assumptions stand up to close scrutiny, or whether they are in actuality harmful to the clients long term savings plans.

As the client for whom the graph above was constructed has herself since discovered, in our numerous discussions over the past two months, there are endless numbers of myths concerning economic issues, the economy, investing, saving etc., [most of which she now assures me she has been "cured" of!] - any one of which could cause serious future damage to the overall value of your long term savings [ e.g.money saved for that "rainy day", or for retirement etc.] if consistently acted on/believed in.


Blog Posts, Free Time, Clients and Responsibilities

As previous clients are usually aware , when I accept a client, in order to really help them, I feel obligated to fully concentrate on their questions, fears , and my answers, for as long as it takes. This can be very time consuming, leaving little time for casual "blogging" [or anything else for that matter!] .

Having just recently finished up with a client, and with none on the horizon for a month or so, I have more free time temporarily and as long as this situation lasts I can devote a little more time to the blog - hence this fairly long new post.

Two Common Myths About Inflation For You to Consider

Briefly examined below are two of the most common myths [and potentially most damaging] regarding the economic scenario labelled " inflation"- a condition which was last of serious concern to US savers and investors in the late 1970's and early 1980's when interest rates on 20 year plus U.S. Treasury bonds peaked at around 15% and gold briefly reached more than $800 per ounce.

What Is Inflation?

For the purposes of this article, inflation is a term used to describe a specific economic state of affairs- that is, a condition which results in a steadily occurring increase in the general price level [i.e. the cost of most goods and services in an economy, as measured by units of the government issued legal tender in use], so that overall, more units of the legal currency [$'s in the U.S.] are required to buy the same mount of goods and services than were required 3 months, 6 months, or a year or more ago.

Cause [a] Versus Effect[b]

Effects of Inflation [b]

The effect of inflation is to make most everything you buy on a day to day basis appear to cost more . You need more dollars and consistently higher wages in order to keep up with the rising cost of living- to buy that bar of soap, see that movie, rent that car, buy gas, light bulbs etc. etc., than you did last week, last month or last year.

I used the word "appear" because appearances are deceptive here.

Cause of Inflation[a]

Actually what has happened is that each dollar [or whatever legal currency you happen to be using], has lost value relative to it previous value, so that now more of them are needed to buy the exact same amounts of goods and services than were previously needed in the past[e.g. last month, or last year]. Each dollar is actually now worth less than it was worth previously.

Obviously this situation can cause considerable anxiety to the average consumer, even without long term savings- this anxiety will increase even more for a person with substantial long term savings which are not sufficiently protected against the withering effects of the inflation - for example, a person with most of their life savings held in municipal, corporate, or government bonds, or even in stocks.

Why?

As to exactly why this [loss of per $ value] occurs, brings us to our first inflation myth:

Inflation myth [1]: "Inflation is caused by increases in the money supply".

Actually, just like everything else, the value, or price of money [i.e. its per unit value, or purchasing power] is subject to the laws of supply and demand, therefor it is more accurate to say that inflation[i.e. a lower value or "price" for each $] is caused by an increase in the supply of money above and beyond the demand for it, with the result that each $ unit loses value.

[Nov.2010 update/clarification: the term "demand for money" on this site refers specifically to the individuals demand to hold on to $'s, or whatever fiat currency being used, and to _not_ spend them.

The desire to hold on to more, or to spend more of a currency is an ever changing factor mostly accounted for by psychological factors that are both unpredictable and individually unique - however the end result will still be a general tendency to hold on to to more, or hold on to less currency units than previously felt necessary.]



Half Truth?

Inflation myth [1] is a half truth at best because logically, using the supply /demand principle, if the supply of money increases, yet the demand for money (i)keeps up with or (ii) surpasses that increased supply, inflation will not result - in fact, if demand consistently outstrips that increased supply (ii), deflation [i.e an increase in the per unit buying power of each $] will inevitably occur!

Impossible To Be More Specific

Despite what you may have heard or read, it is impossible to more specific about the cause of inflation than what I have just outlined : ultimately, inflation is nothing more than a "mismatch", or differential, between the supply of money and the demand for that supply - a mismatch that might occur for any number of reasons.

Inflation Myth [2]: "inflation can be predicted" [perhaps the most damaging myth of all]

Despite my graph [above] that shows a seemingly irrefutable link between the creation of the Federal Reserve system in 1913 and a persistent, historic decline [an almost 100%+ loss in the relative value of the $U.S.from 1913-2000, when measured in year 2000 $'s], Financial Safety Rule #1 says that no economic future event can be predicted with certainty - including inflation.

Therefor, although in my graph inflation appears to be a historical constant and future certainty, realistically there is no hard guarantee or economic rule that says that rampant, incessant ,damaging, inflationary effects and conditions must definitely occur in your own lifetime. It might, but then again, it just might not, it is impossible to know one way or another for certain.

How To Profit From Inflation - Got Money You Can Afford To Lose?

However if you have divided your holdings into 2 groups: [1] money you cannot afford to lose, and[2] money you can afford to lose, I can see no harm in using some, or possibly all of the money you can afford to lose to speculate in certain investments [such as gold bullion] should you believe, for whatever reason, that inflation is about to make a serious comeback. [ newly revised/edited copies of my 17 page guide "Onebornfree's Guide To Safe Speculations" are available free to current clients, and for $250 [Nov.2010 price, subject to change] to non-clients].

Financial Safety Rule #1: Nobody Can Consistently Predict the Future of Inflation

To be clear, neither you, nor I, and no financial graph, no economist [regardless of which "school" of economic thought they adhere to], no investment advisor, no banker, no financial speculator, no "investment portfolio manager", no financial "expert" of any description ,and no other fortune teller of any description can consistently and accurately predict future economic events, including the likelihood or unlikelihood of inflation.

Conclusion

A realistic long term savings plan must protect against the effects of unexpected inflation at all times. Therefor it must always contain elements/ vehicles that easily and safely accomplish this task.

However,putting all of one's long term savings in "inflation proof" investment vehicles is both dangerous and makes little sense in light of inflation myth [2], as it leaves your savings open to large losses in value through the occurrence of other unexpected future economic scenarios [such as deflation], and also does not contain any way of profiting should "good times"[i.e. rising stock markets] make an unexpected comeback.

Notes

* Consumer Price Index general information: http://en.wikipedia.org/wiki/Consumer_price_index

** Log versus Linear Scales

The vertical [y] scale axis uses a log [i.e "logarythmic" or "ratio"] scale of value [see also: http://en.wikipedia.org/wiki/Log_scale ] as I feel that often such a scale gives a more accurate visual representation of change , as changes over the length of time scale [ x- horizontal axis] at any point can be viewed and compared, percentage wise, to any other point in time.

In other words, the viewer may pick any point in time and then quickly measure/compare its percentage increase or decrease relative to a previous point in time.

This is not possible with the more widely used linear vertical scale, which necessarily gives equal weight/value to any point on the vertical [y]axis, for any movement from left to right along the horizontal [x] time axis.
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More About Financial Safety Services

Financial Safety Services is a private , mostly off-line consulting service that attempts to show its real-time [i.e. non-internet derived] clients how to speculate safely with money that they can afford to lose. Money that the client cannot afford to lose should never be risked in these speculations

Nearly all of Financial Safety Services clients to date have been found via direct [i.e off-line, in-person] referral from previously satisfied clients only.

No attempts are made to procure clientele via the selling of the sporadic, incomplete online information posted at this site. All valuable information is sold to clients, via e-mail, or preferably in person, on a "need to know" customized basis, depending on their specific speculative wants/needs.

Therefor any/all posts at this site are for the reference and possible benefit of pre-existing , real-world, paying clients only as part of my services [and to perhaps help emphasize a particular point I make to them in private], and never for the benefit of the general reading public and casual internet reader at large. Internet posts are therfor not made on a regular schedule in order to build an on-line audience; only when I feel that so doing is beneficial to my actual existing clientele.

I likewise have no interest in gaining clients first hand from any posts made either here or elsewhere [if it happens, it happens!] - to date [20 years+], nearly all of my previous clients have come to me via direct, in-person referral from other satisfied clients- that is, [1]an existing client personally recommends my services to a close friend, [2] the friend contacts me, [3]we discuss their wants/needs, [4] I make a decision as to whether or not I can really help them, [5] We come to a financial agreement- or not :-) .

None- Client Questions?

Should a casual reader/none client have a serious question about an assertion I make at this site they must write to me at: onebornfreeatyahoodotcom and I will do my best to answer their question. Their first question will usually be answered for free. After that, fees may apply.

Current Client Questions.

All existing, paying client questions are of course, answered for free [usually via private e-mail]- it is part of the service!
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