Of all the financial topics that can be studied, inflation is one of the most commonly misunderstood. It seems like everyone can complain about it, but few truly comprehend what it means. One reason is that in the U.S., “inflation” numbers are reported as the government’s Consumer Price Index. This number aims to calculate the mean prices of items that we buy on a regular basis. We all know that prices tend to rise each year on average, and we have been conditioned to think that these increases are a normal part of a growing economy. We will touch on the difference between true inflation and what most of us have been lead to believe it is.

Stocks and government

One thing to consider is the way that the CPI is calculated. According to the Bureau of Labor Statistics, they publish “thousands of CPI indexes each month.” As confusing as that may be, it is interesting to note that significant parts of family incomes are spent on two major things that never appear in the CPI. In the book “Whatever Happened to Penny Candy?” Richard Maybury writes that stocks and government are not included in the CPI calculation. He states, “Some economists have long argued that if stocks were included in the CPI, it would be much more complete and would better reflect the true change in prices from the government’s inflation.” Maybury also points out that consumers spend a large portion of their income on government. Both apparent and hidden taxation can be the most costly thing we “buy” but never materialize in official CPI numbers.

Not Rising prices

Increasing prices are a symptom of inflation, not the definition. Inflation is an increase in the money supply. This happens as the Federal Reserve creates dollars that are either loaned to governments or injected into the banking system. If you and I were to do this, it would be called counterfeiting. With the blessing of the government, the creation of money through printing or electronic means is called “monetary policy”. Either way, the increase in the number of dollars has an effect on the supply. This increase in supply causes the value of our money to go down and can further result in price increases for goods and services.

Redefining inflation

Official numbers can say whatever the officials want them to say. What cannot be denied is that over the past decade money has been created at an astonishing rate. All of this has occurred while prices in some segments of the economy have even been declining. An example we can all relate to is electronics. As production has become more efficient, prices have dropped. This should happen in more consumer sectors as the technology to produce things increases. I remember when my family purchased its first VCR in the early 1980s. It was $1,200. If adjusted using official CPI numbers, however, it would cost over $2,600 today. You can buy 50 DVD players for that!

This shows how incomplete the picture of inflation is if we simply look at increases or decreases in prices. We must see it for what it really is, a tax in disguise that occurs as a result of an exponentially increasing supply of money. Truly understanding inflation can help us make wise choices with our investments as we plan for the future.