If you’ve been keeping an eye on the news, you’ve likely been seeing a lot about inflation. It’s one of the most talked about economic issues today. While you can see inflation happening in grocery stores and on gas billboards, there are also statistical ways to quantify inflation. One common way that economists calculate inflation is with a consumer price index (CPI). A CPI looks at the price of a group of goods and compares that to the price of the same group in a previous year. The current price is divided by the previous price to find the inflation rate.
The use of a CPI in the United States dates back to the First World War, when war-driven inflation necessitated an index to measure the cost of living. Initially tallied as regional metrics, in 1921 the Bureau of Labor Statistics started publishing a national average. Today, the CPI is calculated by selecting specific items at specific retail outlets and recording their prices every 1-2 months. Changes in pricing are compared to calculate the rate of inflation. With some variation, this is how most countries calculate their CPIs.
While CPIs provide some information, like most metrics that economists use, they aren’t perfect. One important limitation of the CPI in the United States is that it only measures prices in cities, so the index doesn’t reflect inflation in rural areas.
Another limitation is that an entire category of goods is represented by the pricing of just one item in that category, which could respond to different price pressures than other members of that category. For example, Ben & Jerry’s Cherry Garcia might be selected to represent the “ice cream” category. If Ben & Jerry’s introduced another flavor far better than Cherry Garcia (not hard to imagine) and no one bought Cherry Garcia any more, Ben & Jerry’s might reduce the price of Cherry Garcia in order to sell it. This price change could skew the CPI downward even though more people are buying the more expensive, more popular flavor. The goods in the CPI basket rotate every four years, so over time unpopular items are removed.
One additional potential problem of CPIs is the conflict of interest that arises when governments are tasked with measuring the CPI while at the same time using the CPI to dictate or influence government policy. Depending on the country, the CPI may be used to calculate cost of living allowances, unemployment payouts, and social security benefits, so governments may be incentivized to under-report inflation.
As more and more information becomes publicly available, people are becoming able to create measures of inflation that may be far more useful than a traditional CPI. One interesting project dedicated to measuring inflation that has been created recently is the Billion Prices Project, which uses bots to collect price data from around the internet to create more accurate measurements of inflation. Projects like this show the potential of algorithms and bots in data collection, and how using such tools can improve upon traditional methods.
Clearly metrics for inflation will always be imperfect, but what can investors do when they have inflationary expectations, as many do currently? In times when there is high inflation and it is continuing to rise, investing in the equities market can be a coin flip. However, some sectors have often done better in these times. Stocks in the energy sector and equity REITS have historically done well in inflationary times and value stocks typically outperform growth stocks. Investors can also look to other asset classes, like commodities (Gold or other precious metals are traditional hedges against inflation) or TIPS (Treasury Inflation-Protected Securities). As inflation impacts interest rates, investors can also arbitrage the foreign exchange market carry trade, selling a low-yielding currency to fund a higher-yielding currency.
While these options are often used by high-net-worth individuals (HNWI), some inflation hedges may be less accessible for everyday investors. An interesting investment often overlooked by HNWI is the Series I Savings Bond, because the total amount any individual can invest in these bonds is capped at $10,000 per year. For people with fewer total assets, these bonds may be an attractive hedge against inflation, as they are currently paying an annual yield of over 9% while TIPS are currently generating a negative yield.