4 Ways Investors Get Inflation Wrong

Between fears of a new oil shock and the Fed's money-printing, it's only natural for investors to be concerned about the risk of inflation. If you want to manage that risk intelligently, make sure the following four myths don't trip you up.

Myth No. 1: Rising oil prices will necessarily cause inflation
It was no coincidence that two oil shocks marred the 1970s, the last period of significant U.S. inflation. However, the link between oil price increases and inflation appears to have weakened since 1980. There's a huge wild card, though: the Fed. In trying to explain why higher oil prices have had less of an effect on inflation over the past 30 years, economists -- including Ben Bernanke -- have seized on increasingly aggressive Fed policy as an explanation. The Fed has shown itself more willing to try to counteract the effects of oil price increases (among other things it's been more willing to get involved in).

Sure enough, last Friday, Fed Vice Chairman Janet Yellen declared that the Fed "couldn't sit by" if higher oil prices started feeding through to inflation. But however much she talks the talk, raising interest rates will be a lot trickier while the economic recovery remains fragile.

Myth No. 2: Inflation is underreported by the government
This is a widespread myth supported by an entire arsenal of false arguments. I think this myth is so persistent because people don't find that the government's consumer price index reflects their experience of inflation. But there are multiple explanations for this that don't require a government conspiracy to underreport inflation.

First, the CPI is an average calculated over an extremely broad basket of goods and services; different people consume different subsets of that basket, so it's quite natural that some people will experience higher-than-average inflation. Second, people may overestimate inflation due to "loss aversion": They feel the loss of purchasing power associated with rising prices more acutely than increases in buying power that result from falling prices.

And falling prices do occur: Last year, for example, Wal-Mart Stores (NYSE: WMT  ) reduced prices on more than 10,000 items, including a 22% price cut on Procter & Gamble's (NYSE: PG  ) Tide laundry detergent, for example. In fact, on exiting the recession, Procter & Gamble proactively waged an aggressive price war against rivals Colgate-Palmolive (NYSE: CL  ) and Unilever (NYSE: UN  ) , as well as private label brands. (This year, however, Procter will be raising prices, and I expect its rivals to follow suit.)

Myth No. 3: Gold is an effective inflation hedge
This is a half-myth: As I showed here, gold has preserved purchasing power, but it has only done so reliably over the very, very long term. Over practical holding periods, however, gold doesn't appear to be an effective inflation hedge. Owners of gold-backed products, including the SPDR Gold Shares (NYSE: GLD  ) or the Sprott Physical Gold Trust ETV (NYSE: PHYS  ) , are forewarned. There may be good reasons to own gold during certain periods -- the yellow metal offers some diversification with regard to stocks, for example -- but fear of inflation isn't one of them.

Myth No. 4: Stocks are an effective inflation hedge
All right, this last one is no myth. When investors purchase stocks at reasonable prices, they can expect to earn a positive inflation-adjusted return (over an adequate holding period). But it's important to understand one caveat: Stocks don't automatically protect investors during any specific period in which inflation is flaring up.

In the two-year period from 1973 through 1974, the CPI rose 22%; the S&P 500 only added insult to injury, losing 42% of its value. Stocks are a claim on companies' earnings, and, sure enough, S&P 500 earnings grew faster than inflation over that period. "So what went wrong?" you ask. The trouble was that investors didn't want to own stocks and had sold them down to cut-rate valuations, overwhelming the positive effect from earnings growth. The same phenomenon occurred during the inflation spike of 1946-1947.

It's also worth pointing out that not all stocks are created equal in terms of inflation protection. Which companies are best able to pass on rising costs (and more!) to their customers through price increases? Pricing power is the privilege of businesses that are able to differentiate themselves from their competitors or that produce goods or services people must have. The consumer stocks I mentioned earlier fall into that category. If you're concerned about inflation, take comfort in the fact some of the great franchises in American business are available at reasonable prices right now.

If you want specific ideas of inflation-beating stocks, the Motley Fool's top analysts have identified 13 High-Yielding Stocks to Buy Today.

Wal-Mart Stores is a Motley Fool Inside Value recommendation. Wal-Mart Stores is a Motley Fool Global Gains pick. Procter & Gamble is a Motley Fool Income Investor recommendation. Motley Fool Options has recommended a diagonal call position on Wal-Mart Stores. The Fool owns shares of Sprott Physical Gold Trust ETV and Wal-Mart Stores. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Alex Dumortier, CFA has no beneficial interest in any of the stocks mentioned in this article. You can follow him on Twitter. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 01, 2011, at 4:03 PM, crmeyer81 wrote:

    A CFA that speaks like a true corporatist, blind or corroborative to the true machinations of the super rich trying lighten the middle class of our wealth through deception and misdirection. Just look at the tremendous gap we now have between the rich and the poor that has developed over the past decade. All the Corporations and wealthy individuals that pay little or no taxes, because of government under-reporting of inflation so our wages stay low while our cost of living of food, clothing and energy rise much higher. I'm sick of it all !!

  • Report this Comment On March 01, 2011, at 7:03 PM, xetn wrote:

    "Myth No. 2: Inflation is underreported by the government

    This is a widespread myth supported by an entire arsenal of false arguments. I think this myth is so persistent because people don't find that the government's consumer price index reflects their experience of inflation"

    No, the problem is that the government keeps changing what the criterion is for reporting as illustrated here:

    http://www.shadowstats.com/alternate_data/inflation-charts

    and:

    http://www.businessinsider.com/heritage-foundation-budget-sp...

    "Myth No. 3: Gold is an effective inflation hedge"

    http://www.theundergroundinvestor.com/2010/05/10-gold-charts...

    and

    http://www.caseyresearch.com/gsd/sites/default/files/Dow-Gol...

  • Report this Comment On March 01, 2011, at 7:10 PM, xetn wrote:

    On the assumption that inflating the money supply out of thin air will lead to price inflation (a reduction in the purchasing power) we can see this graphically here:

    http://freedomschool.org/2010/12/19/the-purchasing-power-of-...

  • Report this Comment On March 01, 2011, at 7:24 PM, ETFsRule wrote:

    xetn: You might want to find some sources that aren't as politically-motivated as Shadowstats or the Heritage Foundation.

    A reliable, independant source for inflation data is the MIT Billion Prices Project:

    http://bpp.mit.edu/daily-price-indexes/

    Their annual inflation rate is 2.79%... quite a bit lower than the made-up numbers being reported by Shadowstats.

  • Report this Comment On March 02, 2011, at 9:12 AM, xetn wrote:

    And you might want to consult some sites that are not so Keynesian such as mises.org which of course offers the Austrian view.

    As for the "made up' numbers of Shadowstats, they are just reporting the numbers as they were originally defined (before the government decided that the numbers needed to be massaged to make them appear better).

  • Report this Comment On March 02, 2011, at 10:23 AM, TMFAleph1 wrote:

    <<...before the government decided that the numbers needed to be massaged to make them appear better)>>

    I'm afraid this is disinformation, pure and simple. If you'd bother to examine this proposition instead of regurgitating it, you'd know it is plainly false.

    I recommend you start with this article:

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

    Alex Dumortier

  • Report this Comment On March 02, 2011, at 12:45 PM, derekrlee wrote:

    Alex Dumortier, CFA. His title says it all. Another brainwashed "economic academic" who likely couldn't make a dollar in a bull market. The Motley Fool loses credibility with writers like this....

    Signed, Derek

    A broker and trader with 20+ years of experience

  • Report this Comment On March 02, 2011, at 1:16 PM, derekrlee wrote:

    It is a widely known fact that governments across the world have been under-reporting inflation since virtually the beginning of time. Quite simply, it is in their best interest to do so.

    And how Alex can say "Gold is not a hedge against inflation" is beyond me - for it is so by definition.

    Please stop misinforming the readers, and undermining the intelligence of your audience.

    Then again, I guess that's why you're writing articles for the internet and not trading...

  • Report this Comment On March 02, 2011, at 2:25 PM, ETFsRule wrote:

    "And you might want to consult some sites that are not so Keynesian"

    That makes no sense. Please explain to me what is so Keynesian about the MIT Billion Prices Project.

  • Report this Comment On March 02, 2011, at 3:05 PM, whereaminow wrote:

    Alex,

    The BLS report you cited indicates that

    "In simple terms, when prices change, the goal of the CPI is to measure the percentage by which consumers would have to increase their spending to be as well off with the new prices as they were with the old prices."

    and

    "The goal of the CPI is to measure how much the consumer needs to spend each week to consider herself just as well off as she was before the price increase."

    Question #1

    Does the BLS make the implicit assumption that being "well off" is a static condition that does not change over time?

    If we conclude that society should not progress in material wealth, the BLS' goal makes sense in light of a static assumption. Once we consider that members of a market economy working in a division of labor should see an increase in their material condition over time, the idea of measuring changes on a static condition of "well off" appears foolhardy. How "well off" people are should not only rise over time, but rise in fits and starts in the beautiful unpredicatability that only an entrepreneur-driven economy can produce.

    From the section on candy bars on Page 6:

    "As it turns out, the geometric mean would say that $8 is the amount needed to keep the average consumer at the original satisfaction level. With $8, the consumer could purchase one chocolate bar and four peanut bars, offsetting the reduced number of chocolate bars by an increase in the total number of candy bars."

    Question #2:

    Is the BLS attempting to use objective criteria to determine the subjective values of market actors?

    When I took econ class, the instructor scoffed at my criticism that utility functions were nonsensical, in that you cannot objectively measure things for which there is no objective reference point, i.e. utility. I was told that these are just shortcuts, and no economist seriously believes that you can objectively measure utility. They simply make the models work better. It would appear, however, that the BLS' fascination with geometric mean is more than just a shortcut but rather a statement of fact that they can determine/approximate the subjective values of market actors.

    I would say it's just fancy guesswork.

    I hope you will respond to this question without citing other academic/institutional opinions that are already refenced in the BLS literature. I care not what the IMF thinks of the use of various formulas.

    David in Qatar

  • Report this Comment On March 02, 2011, at 3:14 PM, jk511111 wrote:

    Does the Motley Fool work for the Obama administration or maybe the Fed? 90% of U.S. citizens and most of the people living on this planet will tell you there is inflation. And yes, it is from our governments policies.

  • Report this Comment On March 02, 2011, at 5:11 PM, TMFAleph1 wrote:

    I don't work for the Obama administration or the Fed; in fact, if you look back at the articles I've written over the past several years, you will find that I have been very critical of Fed policies in a number of regards.

    My position on Fed policy don't conflict with my preference for helping to debunk conspiracy theories, rather spreading them.

    Alex Dumortier

  • Report this Comment On March 02, 2011, at 6:35 PM, derekrlee wrote:

    Alex, you wrote "My position on Fed policy don't conflict with my preference for helping to debunk conspiracy theories, rather spreading them."

    Grammatical errors aside, is it really neccessary to label everybody that holds an opinion that conflicts with your own as "conspiracy theorists?" (yawn...) -_-

  • Report this Comment On March 02, 2011, at 7:34 PM, TMFAleph1 wrote:

    Perhaps not, but I wonder: Is it necessary to label someone whose opinion conflicts with yours as an agent of "the Obama administration or maybe the Fed".

    Alex Dumortier

  • Report this Comment On March 02, 2011, at 11:38 PM, TechnologyMike wrote:

    1.5 years ago my coffee was 4.99. Today its 6.81. Is there some sort of global shortage of coffee??

  • Report this Comment On March 03, 2011, at 12:01 AM, TMFAleph1 wrote:

    @dereklee

    My apologies -- I thought that earlier comment was from you.

    However, I'm afraid the idea that the government is manipulating inflation data is a conspiracy theory with no basis in fact.

    To quote from one of Jim O'Neill's recent commentaries, "if inflation is so under-reported, then why does it not show up in inflation expectations surveys when people are actually asked?"

    Alex Dumortier

  • Report this Comment On March 03, 2011, at 3:40 AM, derekrlee wrote:

    Alex, thanks for the thoughtful response. Surely, you must be aware of the countless documented cases of governments from around the world doctoring inflation reports.

    Take Argentina for example: The Argentinian government recently reported a 10.9 percent inflation rate - which was less than half the estimate of private economists and firms like Ecolatina, which pegged inflation at closer to 26.6 percent.

    You can confirm this for yourself here: http://www.nytimes.com/2011/02/06/world/americas/06argentina...

    In response to your question: "if inflation is so under-reported, then why does it not show up in inflation expectations surveys when people are actually asked?"

    It doesn't show up in inflation expectation surveys because said surveys are based upon public perception; which is of course heavily derived from the doctored "Core" CPI, which conveniently chooses to omit the two most important price-level indicators: food and energy...

  • Report this Comment On March 03, 2011, at 3:59 AM, derekrlee wrote:

    Government officials have the incentive and the ability to manipulate economic statistics. The lesson is: don't be fooled by government statistics.

  • Report this Comment On March 03, 2011, at 10:09 AM, TMFAleph1 wrote:

    @derkelee

    <<Surely, you must be aware of the countless documented cases of governments from around the world doctoring inflation reports.>>

    I'm not so much interested in what may or may not have occurred in some other country; I'm not arguing that no government has ever doctored inflation data. Can you produce a documented case in which the Bureau of Labor Statistics has deliberately under-reported inflation?

    Surely you're not equating the level of public sector corruption in Argentina and that in the U.S. In its 2010 Corruptions Perceptions Index report, Transparency International ranked the U.S. 22nd our of 178 countries. Argentina was ranked 105th, with an index level that indicates "a serious corruption problem".

    <<It doesn't show up in inflation expectation surveys because said surveys are based upon public perception; which is of course heavily derived from the doctored "Core" CPI, which conveniently chooses to omit the two most important price-level indicators: food and energy...>>

    Hold on, Derek. The CPI figure that the public is most familiar with is the headline All Items CPI for All Urban Consumers (CPI-U), which does contain food and energy prices.

    Alex Dumortier

  • Report this Comment On March 04, 2011, at 1:50 AM, derekrlee wrote:

    Alex,

    << Surely you're not equating the level of public sector corruption in Argentina and that in the U.S. In its 2010 Corruptions Perceptions Index report, Transparency International ranked the U.S. 22nd our of 178 countries. Argentina was ranked 105th..".>>

    Don't forget that the CPI (Corruptions Perceptions Index) report you are referring to measures exactly what the name implies - perceptions and not "reality".

    That index is compiled from surveys that ask analysts and businessmen, often in the same country that they're analyzing, their perceptions of how widespread corruption is. The reason they don't rely on the number of actual corruption cases is because laws and the enforcement of those laws vary greatly from country to country.

    <<Can you produce a documented case in which the Bureau of Labor Statistics has deliberately under-reported inflation?>>

    No I cannot, although I am not naive enough to believe that corruption isn't a universal problem, and somehow our own government officials are impervious to the temptations of capitalism.

  • Report this Comment On March 05, 2011, at 3:54 PM, whereaminow wrote:

    Alex,

    <<Can you produce a documented case in which the Bureau of Labor Statistics has deliberately under-reported inflation?>>

    This statement leads me to believe that you don't understand (price) inflation. The reason people feel that (price) inflation is under-reported is because no two individual spending patterns are the same. Hence, anyone whose spending patterns are most affected by rising prices in certain volatile sectors are going to think it is under-reported.

    The BLS, fancy guesswork formulas or not, cannot replicate the subjective impact of (price) inflation.

    Whatever conspiracy theories that arise due to constant tinkering and objective imputation of subjective values is the BLS' own fault.

    David in Qatar

  • Report this Comment On March 06, 2011, at 8:47 AM, TMFAleph1 wrote:

    David,

    Perhaps you skipped over this sentence in the article:

    "First, the CPI is an average calculated over an extremely broad basket of goods and services; different people consume different subsets of that basket, so it's quite natural that some people will experience higher-than-average inflation."

    Alex Dumortier

  • Report this Comment On March 06, 2011, at 8:11 PM, whereaminow wrote:

    Alex,

    My point is that you seem genuinely flustered that there would be people who question the CPI. Judging by your responses I conclude that you do not completely grasp this topic.

    These conspiracy theories are a natural outgrowth of 2 things:

    1. A deliberate changing of the meaning of the word inflation from undue monetary expansion to rising prices. You can still find the old meaning in pre- WWII college dictionaries. The new meaning obscures the cause of price rises.

    2. Econometric approaches to measuring subjective value scales - an impossible task that leads to humorous conclusion that every critic of the BLS will be correct. Under-reported? Correct. Over-reported? Correct.

    It's a humorous thing to behold.

    David in Qatar

  • Report this Comment On March 07, 2011, at 8:49 PM, derekrlee wrote:

    David,

    Well said. I realize I am painting everyone with a broad brush here but the reason those with the CFA designation and other economic academics get flustered, as you put it, by these questions directed at the CPI is because you are essentially challenging their entire belief system. It's like telling a devout Christian that there may not be a God.

    These people have spent thousands of dollars paying to be educated in a system that tells them not to question the statistics, and that the Fed is all-knowing, all-powerful institution that has nothing but the citizens best interests in mind. Of course, most of us are smart enough to know this to be far from the truth.

  • Report this Comment On March 15, 2011, at 6:25 PM, johnre55 wrote:

    The upward trajectory of the gold price over the last 11 years signaled not only the inflation of the Greenspan created housing and credit bubble, but in the present day: the emergence of higher rates of inflation in the economy created by the Fed's policy of "monetary ease.."

    Please reference:

    http://www.reiznersway.com/blog/2011/03/inflation_qe2_and_fi...

    Gold may be a good investment during periods of structural imbalances in the economy or during periods where there are demand shocks to the market such has occurred with the rising purchases of both gold and oil from rapidly developing countries recently.

    Gold has secular bull and bear markets just like the stock market. It may be a good investment some of the time. That the federal debt was monetized in the 1970's (as it is being now by Ben Bernanke) led to double digit inflation and a buoyant gold market back then. In that case and possibly today, gold was an effective barometer of inflation. The twin oil shocks of that decade did not help the situation.

    The producer price index rose by 0.8% in January 2011 (a sign of more to come)? May the gold and oil markets be telling us something regarding the potential emergence of high inflation in the next few years? The markets may just speak for themselves.

    Please reference:

    http://www.reiznersway.com/articles/2011/03/can_the_gold_sil...

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