Note that we're not talking disaster here. Also note that I didn't pick that 4% figure out of a hat. I got it by taking a close look at recent Consumer Price Index numbers.
At the end of July the CPI was at 208.3. It was 203.5 a year earlier. That's a 12-month increase of 2.36%. But inflation abated in late 2006. Last September consumer prices fell 0.5%. They fell another 0.4% in October. They were unchanged in November. The index closed the year at 201.8.
What does that mean?
If there is no additional inflation between July and the end of the year, our inflation rate for the year will rise to 3.22% (208.3/201.8). But if the index advances only 0.2% a month, our inflation rate for the year will be a hefty 4.26% (210.4/201.8).
We could, of course, have a replay of 2006. Prices could fall toward the end of this year. But the more likely event is a continuation of small monthly increases. That would give us the 4% inflation rate.
The persistent reality of inflation is the reason I've advocated owning TIPS - Treasury Inflation-Protected Securities - and I Savings Bonds for many years. The Consumer Price Index is less than perfect, but the regular adjustment of principal for inflation makes TIPS a better bet for most investors than CDs and conventional interest-bearing fixed-income obligations.
As I file this, Morningstar shows that the average inflation-adjusted fixed-income fund has returned 4% so far this year. That's well ahead of conventional fixed-income investments. Intermediate-term government bond funds returned only 2.53%.
Low-expense TIPS funds such as Vanguard Inflation-Protected Securities (ticker: VIPSX) and the iShares Lehman TIPS exchange-traded fund (ticker: TIP) did even better, returning 4.94% and 4.86%, respectively, over the same period. If you don't know anything about these securities, today is a good time to learn.
Why?
Because most of us have a fondness for inflation. If you are a middle- or upper-middle-income worker, chances are inflation has treated you well. There are two reasons for this.
- Debt insulated us from inflation. Many middle- and upper-middle-income workers have been able to keep their income growing slightly faster than inflation. If inflation is 3% but you manage to hard-knuckle a 4% raise while having 30% of your income committed to fixed payments on home and car loans, your actual cost of living rose by only 2.1% (70% times 3% inflation), while your income rose 4%. Basically, playing the "I owe, I owe, it's off to work I go" game has been a great purchasing-power protection strategy for the borrowing classes.
- Appreciating homes turned debt payments into higher net worth. Most of middle-income debt is secured by a home that appreciated faster than the rate of inflation. As a result, virtually every dollar spent on mortgage payments went directly to your net worth. Suppose that you own a $250,000 home financed with a $200,000 mortgage. Your annual payment of $14,389 - of which a portion is principal - is magically transmuted into increased net worth if the house appreciates at somewhat less than 5.76%. In much of the country that was a slam dunk.
Unfortunately, that lovely cycle may be coming to an end. If could be a few years. It could be way longer.
That's why we need to look for other venues of inflation protection.
(Questions about personal finance and investments may be sent by e-mail to scott@scottburns.com or by fax to 505-424-0938. Check the Web site: www.scottburns.com. Questions of general interest will be answered in future columns.)
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