What do you like to spend your money on? Like most consumers you probably consume food, restaurant trips, home heating, gasoline, utilities, clothing, medical care, shelter etc. The Bureau of Labor tracks the price of a ‘basket’ of these goods and services every month, and the increase in price forms the Consumer Price Index (CPI).
Have you read the important notes before proceeding any further? It’s a condition.
Personal Inflation Rate
They occasionally change the composition of this basket and they claim that it represents the spending habits of around 94% of the U.S. population. In their words “It is based on the expenditures of almost all residents of urban or metropolitan areas, including professionals, the self-employed, the poor, the unemployed, and retired people, as well as urban wage earners and clerical workers.” More details are here
The following chart show the level of CPI over the last few years, and it’s been averaging around 2.1%.
So that seems pretty comprehensive right?
But does it reflect the inflation rate for those in the FIRE community?
FIRE Community Inflation Rates
It’s commonly accepted that spending patterns change in retirement and there is plenty of material on this issue (example here) However, I wanted to look at whether the spending patterns of those seeking, or enjoying, FIRE might be significantly different to the representative measure of CPI.
So… I enlisted the help of two blogging buddies; Steve at Think Save Retire and I, Vigilante They were two good samples since they both have very unusual spending patterns and I was pretty surprised at the results!
Steve at Think Save Retire
Steve is living the dream. Retired at 35 he now lives in an Airstream with his wife and dogs, and this lifestyle has resulted in extremely unusual spending habits. You can read more detail here.
Initially I had to fit his current spending into the Bureau of Labor’s basket of goods, and this is what I came up with.
The first thing that strikes you is the eye-wateringly high spending on Gasoline. Maybe not surprising that he has a truck towing an Airstream, but 17% of spending on gas is significant. In comparison, my gas spending is less than 6% of total. (I know he uses Diesel and not gas, but more about that later…) Another point to note is that since their total spending of $33,000 per year is relatively low, the medical spending is quite a high proportion. Both gas and medical services can be high inflation items.
Let’s now contrast that with I, Vigilante.
I, Vigilante’s Spending
Again, I fitted I, Vigilante’s spending into the categories provided within the CPI basket.
The obvious thing that hits you here is a huge proportion of his budget goes to a category I have called ‘nominal fixed’. That is actually a student loan payment and mortgage. These are fixed dollar costs and will not change with inflation – hence the actuary-speak of ‘nominal fixed’.
This is a key point here, a large proportion of this budget is not sensitive to inflation. And that is generally a good thing.
Let’s take a closer look at their respective personalized inflation rates.
Personalized Inflation Rates
I re-calculated the CPI index for each of their respective personalized baskets of goods and services. For I, Vigilante I took into account the fact that 61% of his spending was not inflation sensitive. The following chart show their personal inflation rates along with the ‘all goods’ CPI shown above.
There are a couple of things to notice about Steve’s inflation rate. Firstly it is usually above the CPI measure, meaning that he is experiencing higher personal inflation than CPI in general, and it is also more volatile. When prices rise rapidly, his particular basket of goods goes up even faster.
On the other hand, I, Vigilante’s personalized inflation is much more muted. Prices under I, Vigilante’s budget rise much less than under standard CPI.
The average CPI has been 2.1% over this period. In contrast Steve’s average was 2.9% and I, Vigilante was 1.1%.
I think it’s more intuitive to look at how purchasing power changes over time. In each case let’s take $100 and see how the purchasing power will deteriorate over time.
Over this period you can see that under the standard CPI basket of goods, $100 falls in purchasing power to around $65. That’s the power of inflation for you!
However Steve’s dollars are getting eroded much faster. His purchasing power has eroded to around $55! He’s experiencing higher inflation because of the mix of goods and services he is buying, and so he is seeing a faster drop in purchasing power.
I, Vigilante is seeing a much slower erosion in purchasing power. The $100 has only dropped to around $80 over this period. As discussed before, his spending basket is much less sensitive to high inflation.
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Gasoline and Healthcare
The key to Steve’s relatively high inflation rate is the large proportion of his spending on gasoline. See below for the inflation rate on just gasoline compared to the all items basket.
Those are some pretty mad swings in prices right? Sometimes up by 40%, sometimes down by 40%. Gasoline has really volatile prices and this results in a really high inflation volatility for Steve.
Also have a look at the medical inflation rates below.
Prices are not as volatile, but the average level of medical inflation has been running at around 3.8%. So with over a quarter of his budget in these two items, Steve is going to experience some pretty extreme inflationary pressures.
In contrast, I, Vigilante has such a large proportion of his budget fixed in dollar terms that his inflation rate is far below the general level of CPI.
The number one question that ERN and I have received from the Inflation Risk series is asking about how to protect against inflation risk. ERN touched on stocks as providing a long term real rate of return in Part 2
But rest assured we have your back on this! We want to do a deep dive on all the major asset classes and really test whether they provide some level of real return.
However, Steve’s situation is extreme and I wonder whether it would require some unusual thinking. He is particularly exposed to rapid rises in gasoline prices, and if this occurs concurrently with stock market falls, then he could suffer a double whammy – think sequence of returns nightmare!
His big risk is that his purchasing power is being driven by gasoline prices; so how can he reduce this risk? There seems to be two key methods.
- During periods of rapidly rising gasoline prices he could reduce his reliance on this item and simply stay put in one place. This seems like the easiest option to me. Find a nice campsite and stay hunkered-down until the energy crisis passes.
- Look for an asset that will hedge gasoline prices.
Number 2 is a whole series of posts itself that I can’t do justice here, but let’s touch briefly on energy stocks (just coz, ya know!).
Vanguard has a specific index fund devoted to the energy sector (VENAX). Unlike VTSAX, which has a 6% exposure to energy stocks, VENAX concentrates 100% of its holdings in the energy sector. These are names like Exxon, Chevron, ConocoPhilips etc. I’ve shown the price of VENAX alongside gasoline pump prices below.
Pretty damn correlated huh? When gasoline goes up in price then energy stocks rise. No surprise I guess, but this would seem to be a pretty cheap and simple inflation hedge specifically for Steve. Perhaps he could consider weighting his portfolio more to VENAX?
If you’re crying at the thought of the extra volatility that this would introduce to Steve’s portfolio then dry your eyes! Because remember – it’s the real return in excess of inflation that we are interested in, and VENAX will actually reduce risk, not increase it. Since the biggest risk Steve faces is that his portfolio will not keep pace with energy prices. So introducing additional VENAX exposure is risk-reducing, not risk-increasing. Life is so much more fun when it’s real (and not nominal)! [Warning, actuary joke].
Honestly, I don’t love the idea of tilting your portfolio to the energy sector. It feels like so much ca go wrong there, so I think #1 above is the simplest and most effective route to take.
Deflating that Debt!
Whaddabout I, Vigilante? Do I have any sexy investment recommendations for him?
From an inflation perspective he is doing great.
Having a massive student loan does not often produce big advantages in life, but here it does. If I, Vigilante’s income outpaces inflation (usually wages increase faster than prices) then his debt will not only fall in real terms, but also as a percentage of his wealth.
Governments are not above playing this trick with the National Debt. Letting inflation creep up reduces the National Debt in real terms – it’s called ‘deflating’ the debt.
So I suggest to all my readers that they now proceed to Dave Ramsey’s site and promote debt as a great way to mitigate inflation risk. But make sure to wear your flame-proof suits!
Were you surprised that a ‘personalized’ inflation rate could be so different to CPI? Are you concerned for Steve and his high inflation situation, or simply jealous that he gets to swan around in his Airstream? If you retired to an RV lifestyle would you load up on energy stocks to mitigate the inflationary risk? Have you read Part 1 and Part 2 yet?
© 2018 Actuary on FIRE
I know that Steve’s truck runs on diesel and not gas. So I did some digging on this and diesel and gas pump prices are highly correlated. See below.
So for the sake of my analysis I treated them as one and the same.
I was also so concerned by the huge impact gas was having on Steve’s results that I wanted to cross-check my results. So I took the Gas price in 1998 and then rolled it forward with the Bureau of Labor’s gas inflation index. The results almost exactly mirrored actual gas prices. So that gave me some comfort that the BoL was not pulling stuff out its ass.