Inflation is a topic that is widely misunderstood by the public, as well as by central banks and mainstream economists. Nearly everyone just accepts CPI as being ‘inflation.’ What most people don’t know is that CPI is probably one of the most manipulated and misunderstood metrics ever. It has been subject to multiple revisions and methodological changes. Nevertheless, since it’s what the central banks use to set monetary policy, we still need to pay attention to it.
Like most things, it helps to understand it if we strip it back and reason from first principles. This is a timeless approach to understanding problems and cutting through bad reasoning. It’s used by some of the best capital allocators on earth, such as Elon Musk and Charlie Munger.
Let’s start with how CPI is measured.
CPI, or the consumer price index, is measured by the annual change in the price of a basket of goods designed to represent the living costs of the average person. While CPI includes housing construction materials, it doesn’t include land prices or stocks or bonds, or precious metals. In fact, it doesn’t include any assets of any description. The implication of leaving asset prices out of the calculation assumes that you don’t want to own any of the things that a rich person wants to own. In other words, the government’s use of CPI to measure the cost of living assumes that the ordinary person doesn’t want to own assets and be wealthy.
If we were to be precise, inflation itself really shouldn’t even be described by a number. It’s a vector that changes for each person depending on their consumption preferences. For example, if you were someone who wanted to own shares, bonds, property, art, classic cars, precious metals, or anything that a rich person wants to own, your experience of inflation would be far higher than a person living with their parents and consuming fast food and Netflix. Simply because those assets have been rising much faster than both wages and the official CPI number for decades. On the other hand, if you were living at home with your parents and only paying for your phone bill and fast food, your experience of inflation would be much lower.
The problem of asset prices rising faster than incomes creates a social cost, moving house prices further and further from the reach of successive generations. This is why the rich get richer, and the poor get poorer – like a game of Monopoly, whoever owns the assets wins. In Australia, the top 10% of households have an average net worth of $6.1m or around 46% of all wealth. While the bottom 60% has an average of $376,000 or just 17% of all wealth. At the moment, this isn’t too bad by the standards of developed countries, yet the wealth divide is still growing. In America, the top 1% of households hold 32.3% of the country’s wealth, while the bottom 50% holds just 2.6%.
When central banks create money, it creates a range of unintended consequences. Each time interest rates are dropped and money becomes cheap, that excess capital always has a way of finding its way into asset markets and pumping prices up. And this has been a core component of central bank strategy since at least 1987. In the long run, it disincentivises saving and forces people into purchasing assets if they’re to have any hope of maintaining their purchasing power in the long run.