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Understanding inflation
Old 04-15-2014, 05:15 PM   #1
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Understanding inflation

Disclaimer: Still in the learning stage.
.................................................. .......
Let's start off with the CPI... The Consumer Price Index.

Now we all know what that means, don't we? ... Or maybe not!

My IBonds use the CPI to adjust my interest rates.
My Social Security increases are based on the CPI.

So if the CPI goes up X%... I get the same increase both ways, right?

Sorry... this is where the discussion begins.

Here's a first example:
IBond interest adjustments are based on CPU-U For March 2014
minus.2 Percent (minus food and energy costs)
Social Security adjustments are based on Core Inflation... For March 2014
plus 1.7 percent.

Now that's just the beginning... The Bureau of Labor Statistics develops many charts, based on different means of calculation... All apparently developed for specific reasons, for industry, government, and for other specific needs are used by different government departments.

In addition, there are many other ways of interpreting inflation... One of the most well known is Shadow Government Statistics... a "pay" site that purports to present the "real story"... Who knows?

Now... here's where the fun part begins...
Inflation Calculator: Bureau of Labor Statistics
In my case, with nearly 25 years of retirement under my belt, I look back to see what my pay was in 1989, when I retired... $50K... would be the equivalent of about $95K/yr. today.
Hey... suggest you bookmark that site... comes in handy for all sorts of reasons.

Now... here's another website that offers a "FREE" calculator that measures ACTUAL inflation... a whole 'nother story...Measuring Worth - purchasing power of dollar.

This site gives numbers are based on different factors, from standard of living to "economic power"... In my case, that $50K would have an inflated rate of from $83K to $148K.

To understand these numbers, do your own calculation, and read down the page of results, for a better explanation.

So this may not affect anything in that you do in the future... but, going back to the difference between Social Security Inflation and I Bond Inflation...March 2014:
Do a net present value calculation over a 20 year period, and see what happens to $100K.... when you use minus .2 percent and plus 1.7 percent.
See what happens.

Que Sera, Sera...
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Old 04-15-2014, 05:25 PM   #2
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I always use McDonald's ice cream cone. In high school,1984, $.27 cents with tax. Today $1.10. So when I am about 80 years old I will need $4.40.
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Old 04-16-2014, 08:25 AM   #3
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Que Sera, Sera...
A little more about inflation, and how it's to be measured...
Somewhere out there in the ether, there is more going on than most people think. Let's take chained CPI. It is a plan to reduce the Federal Deficit by $390 Billion.
Many younger ER's have stated here that they don't plan on Social Security in their retirement years. That's good in some ways, but maybe mixed blessing, especially if chained CPI comes into effect. Not depending on that (current max) of $32K/yr is probably a good plan, but it certainly pushes up the amount needed for safety into the later years.

You probably already know that chained CPI will reduce future increases based on inflation as it's calculated today. (Core Inflation... which is basically the actual cost of living including all factors. )

Chained Inflation (over simplified) basically says that as cost of living increases, the public adjusts by buying less expensive goods... and that lower amount would be used to calculate cost of living increases.

An example:
Under current CPI... the goverment might use the cost of an auto as part of the "basket of goods" that they use to calculate how much the cost of living has increased... thus affecting the cost of living adjustment.
So today, the average cost of owning an auto may be $9000/yr. As inflation puts a squeeze on household expenses, the owner may keep the car longer, buy a less expensive car and drive fewer miles. This reduces the cost, and that lower cost results in a lower (Calculated) cost of living, and a lower COLA. Makes sense?...Well yeah!... but along the way, the standard of living has decreased. Less travel, cheaper car, lower comfort and fewer amenities.
In the same way, (exagerrated to show the effect of lower standards of living)... That $9 steak is replaced by a $.25 bowl of Ramen soup...

You can see a similar effect on COLA, in the difference between the Core Inflation (March 1.7%) and the CPI-U (March -.2%). CPI-U does not include the rapidly increasing energy and food costs. CPI-U is used to calculate Treasury Bond rates...
Thinking this through, between chained CPI, and the CPI-U, whether you invest in Treasuries or depend on Social Security, you might be lowering your standard of living.
.................................................. ............................
But then, you may have already decided not to rely on SS... so why would any of this affect you?
As mentioned in the OP, the Bureau of Labor Statistics analyzes price indexes in many different ways... Here:
Databases, Tables & Calculators by Subject
The information in these tables is used to calculate many other parts of your life, both directly and indirectly. As a cautionary example, if you are fortunate enough to have a pension with a COLA... know that your COLA is probably calculated using the CPI-U instead of the higher (Core Inflation Rate). Not a part of this discussion, but the various government tables are generally designed to favor the provider, rather than the consumer.

So, back to the beginning... As you calculate your future needs and future income, it might be worthwhile to understand the net present value over your planning time horizon. ie... using an index of -.2% or a +1.7%.

Overall, probably not much you can do about this, but knowing how the system works can't be all bad.
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Old 04-16-2014, 08:42 AM   #4
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The social security COLA is determined by using some of the CPI-U values (series CWUR0000SA0) found here: Consumer Price Index (CPI-W) and here: U.S. Bureau of Labor Statistics and searching for CWUR0000SA0. The specific calculation of the COLA uses the average of the values from Jul-Aug-Sept for one year divided by the same average from the previous year.

It is not clear which values or series are used for I Bond interest calculations. Past I Bond CPI based interest rates used to past SS COLA values do not correlate well. I used I Bond inflation rates from here Individual - I Savings Bonds Rates & Terms: Calculating Interest Rates on I Bonds and SS COLA rates from here: Cost-Of-Living Adjustments.

The federal income tax parameter inflation adjustment uses a different CPI series and a different method of averaging.
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Old 04-16-2014, 09:37 AM   #5
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Originally Posted by Brett_Cameron View Post
The social security COLA is determined by using some of the CPI-U values (series CWUR0000SA0) found here: Consumer Price Index (CPI-W) and here: U.S. Bureau of Labor Statistics and searching for CWUR0000SA0. The specific calculation of the COLA uses the average of the values from Jul-Aug-Sept for one year divided by the same average from the previous year.

It is not clear which values or series are used for I Bond interest calculations. Past I Bond CPI based interest rates used to past SS COLA values do not correlate well. I used I Bond inflation rates from here Individual - I Savings Bonds Rates & Terms: Calculating Interest Rates on I Bonds and SS COLA rates from here: Cost-Of-Living Adjustments.

The federal income tax parameter inflation adjustment uses a different CPI series and a different method of averaging.
No disagreement with any of the above. The details of BLS numbers, and the government use is beyond the scope of anything we could reasonably discuss here. Four hours of trying to wade through the details leaves me talking to myself. My concern is not personal, as none of this will affect me to any degree. What I DO worry about is my kids (and their families), who are now in their 50's. If I have trouble understanding the ramifications of long term inflation, after some serious reading, I wonder if those who are making the decisions really understand the effects on the people, and if the people who are affected, understand what the effect will be on their later years.
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Old 04-16-2014, 10:15 AM   #6
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I call 'chain inflation' the 'Dog Food Adjustment'. Chain inflation says that as steak goes up in price people substitute cheaper cuts for their protein. This leads to pork replacing beef, chicken replacing pork, beans replacing chicken, and then dog food replacing beans. Bottom line is if you can not afford to buy tomorrow what you bought today, your standard of living is reduced. The government should be honest with the people, a novel idea, and just state, 'We can no longer afford to maintain your standard of living', and your SS payments will be reduced. FAT CHANCE!
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Old 04-16-2014, 10:50 AM   #7
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Originally Posted by imoldernu View Post
Chained Inflation (over simplified) basically says that as cost of living increases, the public adjusts by buying less expensive goods... and that lower amount would be used to calculate cost of living increases.
Prices of goods and services are constantly changing. Lots of decreases and sales alongside increases. Consumers react immediately to these changes, so from week to week our purchases vary. We can change many of the items in our shopping basket and keep the same standard of living.

Chained inflation is not intended to measure the shift from higher priced items to lower priced substitutes, it is designed to measure the dynamics of a constantly changing basket of goods and services. The traditional CPI measure is more static and reflects less of this.So, c-cpi is actually a more precise measure of real inflation.
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Old 04-16-2014, 11:37 AM   #8
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Chained inflation is another gimmick to allow the government to reduce benefits while telling the elderly they are maintaining their cost of living.

How the Chained CPI Affects Social Security Payments - US News

The article above explains it, and sums it up in the statement below:

"This change would modestly improve the Social Security system's finances, but result in retirees getting slightly smaller annual increases in their Social Security checks."

In earlier post on this board, it has already been discussed how the present SS COLA does not really keep up with inflation, is there any doubt the new chained inflation will be worse. While this will directly effect SS payments, it will also effect many other retirement systems that base their COLA on similar rational.

While this would have an affect on us, our other pensions and savings will more than make up for it. My point is I want the government to just be honest. The article state that chained inflation will save the government $230 billion over ten years. I have not heard a single proponent stand up and say 'Seniors, we are going to cut your Social Security $230 billion dollars over the next ten years so tighten your belts!'
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Old 04-16-2014, 12:14 PM   #9
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A few links for a better understanding of CPI and c-CPI calculations

The Consumer Price Index—Why the Published Averages Don't Always Match An Individual's Inflation Experience

http://www.bls.gov/opub/mlr/2008/08/art1full.pdf

Frequently Asked Questions about the Chained Consumer Price Index for All Urban Consumers (C-CPI-U)
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Old 04-16-2014, 12:44 PM   #10
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At the heart of the question 'Is the COLA suppose to maintain the buying power of SS payments'. I believe most Americans believe that is what it is suppose to do. When some one is forced to change their shopping list because they can no longer afford what they use to buy, they decrease their standard of living. The C CPI says 'I see you have substituted chicken for beef therefore you don't need as much money' Thereby insuring, if beef does not come down in price, you will never eat beef again.
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Old 04-16-2014, 01:59 PM   #11
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Originally Posted by imoldernu View Post
No disagreement with any of the above. The details of BLS numbers, and the government use is beyond the scope of anything we could reasonably discuss here. Four hours of trying to wade through the details leaves me talking to myself. My concern is not personal, as none of this will affect me to any degree. What I DO worry about is my kids (and their families), who are now in their 50's. If I have trouble understanding the ramifications of long term inflation, after some serious reading, I wonder if those who are making the decisions really understand the effects on the people, and if the people who are affected, understand what the effect will be on their later years.
I agree. The point I was making in a round about way is that the "CPI" is used in a variety of ways that are difficult to understand. Another confusing one is how they determine the "poverty level". For this they use the results of 1950's era spending habits (foods and other) and a nutritional balance of foods determined in the early 1960's and inflate the costs using some of the CPI numbers. It is not a meaningful number in relation to poverty but is used extensively in determining government benefits.

A general observation on SS COLA and federal income tax parameter inflation is that both seem to me to be slightly skewed in the direction of minimizing federal payout and maximizing federal income. Switching to chained CPU for SS COLA would skew further towards minimizing payout.

None of the CPI numbers IMHO are reflective of anyone's personal inflation rate but are an attempt to do something to address inflation in determining taxes and benefits. It is not perfect but it is something and no doubt could be "improved" whatever that means.

If I were to impart an observation it would be that future benefits will be lower and taxes higher, but we all know that already.
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Old 04-16-2014, 02:23 PM   #12
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Seems like much ado about nothing to me if by 2023 SS benefits would be only 3% lower than under current law and it improves the survive-ability of SS.

Quote:
.... According to CBO’s analysis, using the chained CPI-U for annual COLAs would reduce outlays for Social Security (relative to CBO’s current-law baseline) by $1.6 billion in 2014. Those savings would grow each year, reaching $24.8 billion in 2023, and would total $127 billion over the 2014–2023 period. CBO projects that Social Security recipients would face an average benefit reduction of 0.25 percent in 2014 (about $3 per person per month) and approximately 2 percent in 2023 (roughly $30 per person per month). That estimated average reduction in 2023 reflects larger percentage cuts (of up to 2.5 percent) for people who are already receiving benefits today or will become eligible for them shortly (and who thus would have experienced smaller COLAs for nearly a decade by 2023) and smaller cuts for people who will become eligible for benefits later (and thus would have experienced smaller COLAs for a shorter period of time in 2023). By 2033, outlays for Social Security would be 3 percent lower than they would be under current law, or 6.0 percent of gross domestic product (GDP) rather than 6.2 percent. As a result, the gap between Social Security’s outlays and tax revenues in that year would shrink by about one-sixth...
What Would Be the Effect on the Deficit of Using the Chained CPI to Index Benefit Programs and the Tax Code? - CBO
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Old 04-16-2014, 02:47 PM   #13
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Seems like much ado about nothing to me if by 2023 SS benefits would be only 3% lower than under current law.



What Would Be the Effect on the Deficit of Using the Chained CPI to Index Benefit Programs and the Tax Code? - CBO
The little bit here and little bit there adds up to quite a bit.
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Old 04-16-2014, 02:51 PM   #14
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Not sure about that, but the way the AARP is railing against chained CPI one would think it was gutting the program rather than reducing benefits by about 1/4% a year.

That is part of the reason why I didn't renew my membership - they overplay everything that has an adverse impact on seniors, no matter how minute. In the long run our kids will likely make much larger sacrifices to save SS - so for beneficiaries to sacrifice 1/4% a year doesn't seem to be a huge ask.
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Old 04-16-2014, 03:52 PM   #15
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The impact is much broader than Social Security. TIPs and tax rates are also indexed, wages and spending are judged against CPI and many are also indexed. While chained CPI may result in lower increases in cost of living adjustments, there is no evidence or research that shows c-CPI will understate future inflation, while there is considerable support showing that current CPI calculations overstate the effect of inflation.

This will mean future SS payments will be lower. It is possible, however, that past COLA adjustments have been excessive and, when (if) c-CPI is implemented they will then normalize. So many arguments and discussions about chained CPI are really objections to a projected lower SS pension. The concern has merit, but the problem is not the CPI calculation (IMHO).
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Old 04-16-2014, 06:59 PM   #16
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So, this is my simplistic perspective on inflation:

First and foremost, it's about the prices of goods and how they change (increase) over time. So my first concern are my expenses, and what they might look like in the future. Given the positive tendency of price inflation and the government's feeble attempts to manage it within certain bounds, I go with the 3% long-term average for simplicity. I do all my planning against current-year expenses and inflate them 3%/yr for whatever term I'm considering, currently 40 years. I also use my mandatory expenses for my baseline.

Now I turn to income, and I have tried to book a combination of sources that keep the monthly income well-above monthly (inflated) expenses. Some of my sources are COLA-adjusted, some are not, so I worry the aggregate of them in staying above the line. All sorts of schemes and games are in play regarding COLAs now, but my concern is the total effect of all sources. I'm happy to say that my current plan has plenty of margin in my 'active' retirement years to cover travel and fast cars. The income line gets close to the expense line late in life, but at age 100 I'm thinking the fast cars will be long gone...

I do put these alternate COLAs into my model to see what they do, and it can be somewhat dismaying. But any of the prognostications are just that, informed guesses, so I'm not worrying any particular percentage point, just the aggregate of the incomes.

Here's a plot I did for my kid. who turns 23 today (Happy Birthday, Matt):



Blue Line (left Y axis): $2000/mo of expenses in 2013, inflated 3%/yr.
Gold Line (left Y axis): Income, starting at age 67, comprised of 1) SS, $5559/mo COLA'ed at 2% (from the simple SSA.gov calculator), and 2) Savings, $7800/mo, no COLA
Red Line (right Y axis): Savings balance, contributing $800/mo starting in 2013, ending at age 67, assuming a 5% rate of return.

Note the income line starts about 40% above expenses, gradually comes to an intersection with expenses in 2087, age 96.

Now, if a COLA'ed income source were my only source, I'd worry the chained CPI question a lot more. But its the aggregate of all income sources that determines whether you can cover expenses, and it's fundamentally the eventual actual price inflation you need to worry, and it isn't following some pre-determined calculation...
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Old 04-16-2014, 07:45 PM   #17
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Seems like splitting hairs here about fractions of a %. Am I alone in remembering the '70's-early '80's? For the decade from '73-'82 annual BLS-CPI inflation averaged 8.8%, inc ave ~12%/yr for '79-'81. Now THAT was inflation!!! (And the reason long bonds now look scary to me).
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Old 04-16-2014, 08:22 PM   #18
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Am I alone in remembering the '70's-early '80's? For the decade from '73-'82 annual BLS-CPI inflation averaged 8.8%, inc ave ~12%/yr for '79-'81. the reason long bonds now look scary to me).

Not at all. I remember people investing in all sorts of foolishness to try and keep ahead of inflation. I also remember the double digit interest rate 10 year treasury bond I bought back then with great affection. 😃
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Old 04-16-2014, 08:26 PM   #19
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The only inflation I recall from the early '70s was the horrendous increase in gasoline, right after I got my driver's license...
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Old 04-16-2014, 09:41 PM   #20
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I went through some of the links on this page to understand how the substitution effect works in the CPI calculations (both chained and unchained). I also found a fairly detailed paper on the calculation at http://www.bls.gov/cpi/super_paris.pdf

So here's my understanding and someone please correct me if I am wrong. Substitution of items can occur for both CPI-U and C-CPI-U (chained CPI-U).

For CPI-U the substitution effect comes into play by taking the geometric mean of prices for a group of like items. The examples that come up are things like two different varieties of apples (granny smith vs red delicious). BLS will measure the change in price of all apple types but they will take the geometric mean to compute inflation. The geometric mean will naturally down weight whatever apples happen to be more expensive. CPI-U does not allow substitution between very different items like chicken for beef.

For Final C-CPI-U (final chained CPI-U), the substitution effect comes into play by updating the reference basket on a monthly basis. So if beef prices rise rapidly and consumers start buying more chicken, beef will be down-weighted in the inflation calculation because consumers choose to buy less of it. I guess the assumption is that BLS can find a group of people who are maintaining a constant level of consumption satisfaction to determine what is in the reference basket. In contrast, for CPI-U the reference basket is only updated every 2 years.
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