Is the Government Manipulating Inflation Data?

Investors have a lot on their minds right now. Has this year's rally come too far too fast? Are we due for a "V" or "W"-shaped economic recovery? Is out-of-control inflation just around the corner? And while the last thing folks need is something else to worry about, there may be new concerns afoot that inflation is actually worse than the data would lead us to believe.

Deflating expectations
There has long been debate about whether the widely used Consumer Price Index, or CPI, accurately reflects inflation. A recent article in Investment News, though, brought the issue to the forefront again, asserting that the government may be keeping official measures of inflation artificially low.

Most of the concerns center around how the Bureau of Labor Statistics (BLS) handles two calculations: its adjustment for consumer substitution of goods and its measure of the costs of home ownership. Critics charge that current methodologies assume that consumers shift toward lower-priced good as inflation rises with no loss in standard of living, which creates a downward bias in CPI figures. Likewise, the BLS uses a rental-equivalent measure to estimate home prices, rather than actual home values, which may have had the effect of lowering the rate of inflation during the recent housing bubble.

Any errors in the CPI affect millions of people. Retirees who receive Social Security payments rely on CPI data for their annual cost of living adjustments. If the government is keeping inflation figures artificially low, retirees will gradually lose their purchasing power over time as their payments fail to keep up with actual inflation. Similarly, investors who buy TIPS and other inflation-linked securities will also face declining purchasing power as their returns fail to keep pace with rising prices.

An imperfect solution
Of course, no matter what the government does, CPI will never be a perfect measure of inflation. It would be nearly impossible to accurately track a completely true measure of inflation that incorporates consumer decisions in the face of shifting prices, the costs of borrowing money, and innumerable other factors. CPI is an imperfect tool, but it's as close to a workable solution as we have.

Yet one thing is for sure -- increasingly, the government has a financial incentive to keep a lid on inflation numbers. Considering the vast sums of Social Security payments and TIPS interest and principal payments, lower inflation adjustments mean less outflow of government funds.

Inflation-fighters to the rescue!
Unfortunately, you can't do much to solve CPI calculation problems. Instead, we should make sure that we do what we can to handle rising levels of inflation on an personal level.

First and foremost, we need to make a concerted effort to stock our portfolios with the greatest long-term inflation fighters around -- stocks. No other asset class has produced greater returns over long periods of time. And when it comes to knocking inflation for a loop, higher returns are what counts.

Consider the performance of some of the biggest names in the S&P 500 index over the past 10 years. Even with two major bear markets during this time period, look at how the long-term power of equities can work to your advantage.

Source: Yahoo! Finance. As of Nov. 27.

Even investors who are currently in retirement need a hefty dose of stocks to keep up with inflation. Bonds alone, even inflation-adjusted bonds, won't do the job by themselves. Even if you're 65 years old, you might reasonably expect to live another 20 to 30 years. To maintain your purchasing power and keep your portfolio growing during that time, you need stocks.

For those of us who are still decades away from retirement, stocks are even more important. If a rousing bout of inflation is right around the corner as many predict, you're going to need stocks, of both the domestic and foreign variety, to get through the worst of it.

Many investors and money managers alike are reacting to the fear of inflation by moving heavily into traditional "inflation" assets like commodities. While adding a small slice of commodities to your portfolio may serve as a decent diversifier, these asset classes have not historically held up as well as stocks over the long run.

Don't count on commodities to juice portfolio returns. They may add a boost in the near-term, but they are likely to trail stocks over long periods of time. And, when we're talking about inflation, the long run is what counts.

Be ready
Regardless of whether or not the government is acting to keep a lid on official inflation numbers, you should prepare for the worst in your own portfolio. Fortunately, you're probably already doing much of what you need to do to guard against inflation -- making stocks your new best friend.

If you're afraid of inflation, you'll want to avoid making bad moves with your money. Read why Alex Dumortier thinks one investment is the new subprime.