HardAssetsInvestor

Understanding Inflation

Commodities and inflation are in the same headlines time and again. So what's the connection?

• The real definition of inflation
• Commodities as an inflation driver?
• Commodity investments as an inflation hedge?

Commodities and inflation are in the same headlines time and again. So what's the connection?

It's always good to start with a definition, even if you lived through the double-digit inflation of 1974-75 and the early 1980s and know what inflation is firsthand.

Here, then, is that definition, courtesy of Webster's:

in·fla·tion

A continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services

Now let's bring that back down to the real world.

Everything in the world changes with time. Seasons shift, people grow older and prices move up and down - in some cases with each tick of the clock. We humans have a compulsion to label things, so when prices persistently go up, we call it inflation. When prices go down, we call it deflation.

The tricky bit to remember is that with rising prices, we get a corresponding decrease in purchasing power. For example, a candy bar that cost $1 in 2003 would cost roughly $1.15 today - or to think of it another way, if you only wanted to spend $1, that same stale candy bar would be slightly smaller today. In order just to stay even - to have the same basic wealth - you're source of cash flow (investments, paychecks, lottery winnings) has to at least keep pace, or you're literally becoming poorer, no matter what the numbers in your bank account look like.

Measuring Inflation

To make sure we're comparing apples to apple, U.S. inflation (and deflation) is calculated based on a specific basket of things consumers actually buy every day - captured in the Consumer Price Index (CPI), published in the U.S. by the Bureau of Labor Statistics.

In practice, what we refer to as the CPI is really the CPI-U: The CPI for All Urban Consumers, which is a basket of goods and services commonly purchased by urban households. The CPI-U is designed to represent the average, real-market experience of 87% of the households in the U.S. When headlines talk about the CPI, what they usually mean is the CPI-U.

Another oft-headlined index is the Core CPI - the CPI-U without the items in the basket that are directly food- and energy-related. Why would anyone remove food and energy? After all, I know that my oil, gas and grocery bills make up a very large part of my household budget.

Well, since the CPI is watched as a yardstick for monetary policy by many economists and policy makers, the idea is that food and energy are subject to short-term microeconomic supply-and-demand shocks, and are thus too volatile to be a good yardstick for assessing the impact of monetary policy. (In other words, food and energy prices change too quickly.) But since most of us live in the real world - not the monetary policy theme park - we typically refer to (and journalists report on) the CPI-U, and not the core CPI.

Included in the CPI are things like food, beverages, housing, apparel, transportation, medical care, recreation, education, communication and other goods and services. Also included in the basket are all the little taxes and fees that make this nation great - things like auto registrations, water and sewer taxes, etc. Income and Social Security taxes are not included. (To learn more, visit the CPI's home at the Bureau of Labor Statistics. It's great nightstand reading.)

There's a third set of inflation indexes we should be paying attention to as commodities investors, however, and that's the Producer Price Indexes (PPI). The PPI, instead of measuring what consumers spend, measures the actual amount that producers receive for their goods. Here's how the BLS describes it:

Besides highlighting the difference between purchasers and consumers, the main differences between the two indexes is that the PPI is only domestic, and it removes the entire retail service sector from the equation, both of which can be seen as "noise" if you are trying to understand nuts and bolts U.S. economics. The CPI, with its consumer perspective, collects data on anything that is bought by consumers, and includes imports, as well as sales and excise taxes. PPI is just the price the producer gets for its good.

There's some belief among economists that because the PPI is less volatile, and that it may in fact be a better longer-term measure of shifts in the economy. But that is a subject we'll leave to the economists. From a commodities perspective, since consumers don't directly consume #2 Field Corn and Crude, the PPI is one step closer to the actual industrial transactions that drive commodity prices.