The Stealth Tax

"Inflation is when you pay fifteen dollars for a ten dollar haircut that you used to get for five dollars when you had hair." - San Ewing

"Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man." - Ronald Reagan

"Inflation is taxation without legislation." - Milton Friedman

From the quotes above I am sure that you get the picture, inflation is the stealth tax that decimates retirement planning and steals money right out of your wallet while you stand and watch it happen.  There is nothing you can do to stop it but you can prepare for it and if you do this will go a long way to fulfilling your retirement and investment goals.

First of all let's look at the most widely used measure of inflation the Core Inflation rate.  Core inflation refers to the long run trend in the price level.  What it tries to do is strip out any "noise" or wild swings in prices caused by one off exogenous shocks, say for example a temporary spike in the price of gasoline due to a strike at the refinery.  The problem is that doing this strips out the most volatile items namely energy and food and these two items account for a large portion of most individuals monthly budget.  Now the question is how is the Core Inflation calculated?

Well there are numerous ways to calculate this number.  The most widely used methodology is the Consumer Price Index or CPI.  This measure was used by the Federal Reserve for years but has recently been dropped for Personal Consumption Expenditures Price Index or PCE.  Many people still rely on the CPI as a gauge for inflation, for example social security payments are index to the CPI so let's look at how the CPI is calculated.   Essentially CPI is a basket of consumer goods excluding food and gasoline.  The idea is that as this basket of goods changes prices a relative measure of inflation is calculated.  The problem with this concept is that while consumers change their buying habits fairly regularly the basket of goods was set for an extended period.

For this reason the Federal Reserve recently changed over to use the PCE.  This takes into account the ever changing consumer preference for different items and has resulted in a lower number being calculated for the United States inflation rate by about 30%.  This is significant in that the Federal Reserve has as its mantra to keep a lid on inflation and by changing the way that they calculate inflation they have magically lowered inflation.

Another problem with calculating inflation is that it is extremely difficult to adjust prices for the improvement or benefit from using say an iPhone 5 versus an iPhone 4.  The 5 may cost more but if there is a benefit from an improvement in living standards then just looking at the price increase is not capturing the improvement and so the Federal reserve makes an adjustment for this lowering once again the inflation rate.  In addition to this adjustment they also make seasonal adjustments to strip out seasonal influences on prices thereby tinkering again with the published rate.

So what is the real rate of inflation?  Well as we have seen the number published is anything but accurate.  It serves a purpose for the Federal Reserve but really has no bearing on the rate of inflation that you personally bear.  You buy gasoline and food and I am sure that your basket of goods is vastly different from the Federal Reserve's published basket.  In fact not only is your basket different from the Feds but it is more than likely different from mine.  This means that your inflation rate is different from mine and, if you want to get nit picky, different from everyone else's.  To dig even deeper, even if you buy exactly the same things as your next door neighbor if the timing of the purchases is different there is a high probability that you will pay different prices.

So while we all have a different inflation rate it is this inflation rate that you need to consider when you look to a real rate of return on your investments.  The real rate refers to the rate of return in excess of the inflation rate.  This is the rate at which your portfolio is actually growing as inflation is eating away at the rest of the returns.  This is why it is important to not only review your spending habits to determine a personal rate of inflation but it is critically important to factor in the rate of inflation and the impact it is having on your portfolio returns.  Turning a blind eye to the rate of inflation will severely impact your ability to retire happily as the stealth tax will destroy your portfolio much like termites destroy a wooden house.