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SSep 5, 2007

Re-Thinking the Joys of Inflation

Scott Burns

     This year may be the first since 1991 with a 4 percent inflation rate. After years of running just under 3 percent, a 4 percent rate will be a shock, particularly since it won’t apply to home prices.

    The combination of slowing wage gains, higher inflation, and lower home prices could mean stagflation. Worse, the escape road we’ve enjoyed for many years, the great Home Equity Credit Freeway, may be closed for repairs.
    
    Note that we’re not talking disaster here. Also note that I didn’t pick that 4 percent 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 percent. But inflation abated in late 2006. Last September consumer prices fell 0.5 percent. They fell another 0.4 percent 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 now and the end of the year our inflation rate for the year will rise to 3.22 percent (208.3/201.8). But if the index advances only 0.2 percent a month our inflation rate for the year will be a hefty 4.26 percent (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 percent 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 4.00 percent so far this year. That’s well ahead of conventional fixed income investments. Intermediate-term government bond funds returned only 2.53 percent.

   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 percent and 4.86 percent, 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 percent but you manage to hard knuckle a 4 percent raise while having 30 percent of your income committed to fixed payments on home and car loans, your actual cost of living only rose by 2.1 percent (70 percent times 3 percent inflation) while your income rose 4 percent. 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 percent. In much of the country that was a slam dunk.


    Small wonder so many of us are house addicts.

   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.

On the web:

Recent figures for the Consumer Price Index, all urban consumers:


Most recent CPI figure (August CPI release will be on September 19, 2007)
 

The Big Picture: Case-Shiller Home Price Index Posts Record Annual Decline
 

OFHEO Home Price Index Shows Smallest Quarterly Increase since 1994
 

Morningstar mutual fund category returns:
 

Filed Under: Mortgages