“Killer Flation” And the Vanishing Middle Class

A World in Transition

June 2011

By Tom Cammack, CFA, CPA
Author of INFLATION NATION

“It should never be forgotten that the one decisive factor in the rise of totalitarianism on the Continent, which is yet absent in England and America, is the existence of a large, recently dispossessed middle class.”  The Road to Serfdom, Chapter 13, F.A. Hayek, 1944.

This is Part I of a series that discusses long-term trends that should continue in 2011 and beyond. This article will discuss inflation and what is happening to middle class families in the USA and most of the developed world.

Inflation is defined by Webster’s Dictionary as “a general rise in prices brought about by an increase in the ratio of currency and credit to the goods available.” When the general price level rises, each unit of the functional currency buys fewer goods and services; consequently, inflation is a decline in the real value of money—a loss of purchasing power in the medium of exchange. A chief measure of general price-level inflation is the general inflation rate, which is the percentage change in a general price index (normally the consumer price index) over time. My personal favorite measure for measuring inflation is the price of gold.

Inflation is simply the decline in purchasing power of money. It redistributes wealth from savers and lenders to borrowers. The value of savings declines, but so does the value of debt. Conversely, in a deflationary environment, the purchasing power of your money rises, and wealth is transferred from borrowers to savers and lenders. The value of your savings rises, but so does the value (burden) of your debt.

What is the True Inflation Rate?

This is not an easy question to answer. Most people rely on the Bureau of Labor Statistics (BLS) monthly reported Consumer Price Index (CPI) numbers. The BLS reports CPI numbers monthly in two ways: the normal “headline” CPI and “core” CPI (which excludes food and energy). This differentiation was put in place in an effort to evaluate CPI results without the more volatile food and energy components. However, I believe we would all agree that food and energy costs are critical components of CPI, and they are the main drivers of inflation expectations for most people. It seems to me core CPI is only relevant to certain economists and dead people.

Before addressing this subject more extensively, we should take a look at what comprises the CPI. The chart below shows the items in the CPI basket:

As shown in this chart, Housing (Owner’s Equivalent Rent) makes up over 40 percent of the index.  As a result, the monthly reported CPI numbers are heavily influenced by the Housing component of CPI. The next largest item is Transportation at 16.6 percent. The main point of this discussion is that weakness in Housing CPI can easily mask what is happening in other categories.

The headline CPI rate reported for April 2011 was 3.2% (year-over-year change). Most experts describe this level of inflation as being tame and that the rise in energy and food prices will be temporary. Time will tell if these price increases are temporary or not. I would like to note that  the overall headline rate can mask some important details. Here is an example. For the year ending April 30, 2011, here is a list of the five most inflationary and the five most deflationary items according to government statistics:

I have a question for you. Which do you believe had the most impact on the average person: a significant rise in food and energy prices or a drop in television prices? The point of this true life example is that the overall headline CPI can mask some significant increases in our true cost of living. It’s difficult to see how any living American had an inflation rate of only 3.2% in April 2011. I believe the CPI calculation methodology understates the true inflation rate for most families, especially suburban workers who commute to and from work.

The Vanishing Middle Class

It seems clear to me that many middle class families are struggling to make ends meet. For these families, survival is more important than investing. Here is a quote from a radio program series done by Anthony Brooks of WBUR radio station in Boston:

Middle class American families are in distress. Despite the enormous increase in wealth in America over the past two decades, for most Americans in the middle, wages have been flat—or even losing ground. At the same time, the costs of basic necessities, including housing, health care, food and education have continued to rise. The recent economic slow-down, combined with the melt down of the real estate market, has made clear that the very fabric of the American dream is being ripped apart. That dream was once embodied by the stability of the middle class, and the idea that hard work and playing by the rules would be rewarded by a fair wage and the possibility to move up the economic ladder. But that is no longer the case for millions of hard working Americans. For them that dream has been transformed into growing economic insecurity, and in many cases, actual economic struggle. The Vanishing Middle Class: Inside Out; special series, 2008, WBUR radio station, Boston, Anthony Brooks, series reporter.

As we go forward, I expect the Fed and other central banks to be successful in creating inflation. However, it may not be in the manner they desire. Sometime in the not-too-distant future, it will be time to reap what we have sown. Currency debasement inflation is likely to occur simultaneously with credit contraction deflation in financial asset prices. This combination results in much confusion in the inflation/deflation debate. In fact, we can both at the same time.  The result, in my opinion, is what I call “Killer Flation” – K-flation:

Source: InflationFighter Investments LLC

(I am aware some people call this bi-flation; however, I do not believe this term adequately describes what is occurring and impact it is having on the middle class).

About the Author

Tom Cammack is an experienced investment professional with over thirty years of financial industry experience and author of the book INFLATION NATION. Tom started investing personally in the 1970s and is currently a senior investment manager with a large public pension fund where he has worked the past 20 years. During this time, Tom has invested in gold, silver, and other natural resource companies all over the world.

References made to third parties are based on information obtained from sources believed to be reliable, but they are not guaranteed to be accurate. Readers should not regard these references as a substitute for the exercise of their own judgment.

Copyright 2011. All rights reserved.