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%.
Purchasing Power
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.
Inflation Hedging
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!).
Energy Stocks
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?
Nope.
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
Technical Notes
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.
We are like I, Vigilante. Most of our expenses also come from fixed items, and will not go up with inflation. The problem with fixed items is that you can’t cut down on them if you want to. Any magic fix for that?
No magic fix unfortunately. But I guess that will change as you move into retirement later in life.
Fascinating concept personal inflation. Since retirement I drive far less so gas consumption is less, but so is the actual cost of mileage and I expect my car, tires etc will last longer. I specifically purchased a new car the year before retirement to take advantage of a long vehicular life. Cost tracking has improved my spending efficiency resulting in lower monthly expenses. Less fast food less dining out etc. Owning my home I think adds to a reduction in personal inflation. Probably something like solar over time would pay off as well. Job expenses are pretty much gone. I’m going to keep my medical license active for another 2 years till I’m well into retirement, then let it go. The first thing I thought of when you described the problem was to view it as SORR. Another hedge is to have an abundance of available money relative to withdrawal. If your WR is say 2.5% and inflation creeps up 1% the WR is still pretty low. Your point about reduced risk is spot on. I spend most of my time thinking ab out how to reduce risk.
It turns out that taxes are an incredible often never mentioned risk. I’ve been optimizing Roth conversion and discovered if a spouse dies taxes on the remaining spouse often go up 2 brackets. It’s even worse if you don’t Roth convert BY A LOT! Taxes are not considered part of CPI but they should definitely be part of personal inflation. Talk about bad SORR first you spouse dies and then the govt comes and swipes 30% of your dough. Roth conversion is the way to manage that risk.
Were I Steve I might consider an electric bike. That way you don’t have to crank up the truck to go to Mickey D’s or Walmart. Power at camp sights is free, making the ride to Walmart and back free.
I think there is definitely a SORR angle to this. But I have not quantified it. I think for regular consumers it might be pretty small, but for Steve it could be a real issue since he gets such huge spikes in personal inflation.
Urgh taxes. You may never see a tax post on my site. Principally because all my clients are tax exempt (DB pension plans, endowments, foundations, DC plans etc). And taxes are not my strong point.
But ERN has that covered…
Interesting concept for a post. We sit somewhere in the middle with mortgage providing the inflation hedge. There are some benefits to a mortgage after all
yeah, that’s what I keep telling myself! Thanks as always for coming by FtF
Have you guys considered oil futures (wti or Brent) to hedge with? I think IA would let you trade those. There’s probably a oil future etf though with a slight negative carry for the roll.
As for pharma, have you looked into if investing in the healthcare industry would correlate with rising healthcare costs? Minus the SP500 performance as a benchmark.
My own health insurance is set to go from $140 now to $500 at 30 when I plan on FIRE’ing so it’s prettt concerning. And that’s with a $7500 deductible! Insanity. Not sure how much it goes up after that.
Oh man – you’re floating my boat with oil futures! That would surely be a better and more capital efficient way to get the hedge. You could hedge more than a dollar of exposure with leverage, so I like that idea!
There was a lot of talk in actuarial circles about using pharma stocks as a hedge to longevity! But that is an interesting ideas about hedging medical care costs. I might look into that…
Thanks for coming by, and commenting.
Loving this series. I never thought about how much a persons spending by category can be impacted by inflation.
The good news for Steve is that he can drive less. The people who figured out how to retire in their 30’s are smart. If gas goes up 10X he can stay in one place 10x as long and poof, his costs stay the same. I love your idea about using investments to hedge. A total market or S&P 500 index fund is great for most people. Sometimes digging deeper can reduce a specific person’s risk. Well done.
Thanks Jason. I was pretty pleased with this, as it turned out a lot more interesting than perhaps I thought.
Wow, you were able to glean a lot of information from my spending stats! This is beautiful and informative….how much do I owe you? 🙂
What I’m curious about now is this: I wonder how much different would my “personalized inflation rate” would change if the fixed expenses were removed? In other words: How severe of a shock am I in for when my student loans are paid off, and more of my dollars are being spent on things that are more readily susceptible to inflation? Will I suddenly worry about inflation, which I tend to ignore today since my largest expenses are fixed and increases to my income drastically outpace the CPI? Not something you have to figure out, of course – you’ve done more than enough! – but an interesting thought about how dramatically a personalized inflation rate may change over time!
Hmmm good question. I would expect that without the loans you would be around the CPI level. Your personal CPI would go from about 1.1% to about 2.1%. So your assets would need to work harder to earn the same real return. But you won’t be paying your student loan anymore, so will have more assets to play with 🙂
You were a great case study – so thanks a million!
Very cool concept. The fuel issue (and your suggested hedge) reminds me of the airline industry. LUV has played that game pretty well over the last decade or so.
Our budget (single breadwinner, spouse and two little ones at home) is vulnerable to medical and food inflation. Rather than hedging, we are looking into a concierge medical plan. And eating less ?.
Great post!
Great post! And a nice segue to my upcoming post (probably one week delayed to March 28). Gasoline is one of the most volatile components in the CPI. But going forward, I hope that U.S. shale production as the new marginal producer could reduce volatility: come online quickly if prices rise, go offline if prices are too low.
Cheers!
Karsten
Of course 🙂 this is fascinating.
I would be interested in reading an article about how correlated healthcare premiums are with pharma beta (sp500 return – pharma return). Or maybe there is a better indicator?
I’d test it in myself but I guess I only have 3 years of data….
You do very awesome research here on this blog :). Def a reader now!
Olivia – thanks for coming by and the kind words. I also want to look at the whole issue of healthcare inflation. Many people are asking for that…
This is a great way to reconsider the topic of inflation. I just took a look at our spending from 2017 to see where we are and the verdict is that we’re much closer to Steve. I’ve never thought of investing in a way that hedges our personal inflation rate. What an interesting concept. I love the way you think.
Thanks for coming by Susan
I was thinking, Roth conversion might be a pretty good pain free inflation hedge. You get the growth part tax free.
Not sure I get you. Do you mean that since the growth is not ‘dragged’ by taxes that provides more return to compensate for potentially higher than expected inflation?
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I am impressed – outstanding work, with a sense of humor!! I tried to log a complaint via the formal complaint procedure but struggled… I continue to ponder the value of my fixed nominal expense (I love your actuarial term for mortgage) and the virtues of carrying it into early retirement. A fixed 2.875 rate isn’t too bad and may be worth holding and considering as a monthly expense for a decade…
GXA – thanks a million for visiting! I think a mortgage is fine in the accumulation phase, but you need to be careful in the spendown phase since it is an expense that cannot be flexed if you come up against a poor sequence of returns.
Don’t be a stranger.
Thank you for the reply. If I choose to RE in five years (age 47 with 10 years left on the mortgage), I will have to part with a chunk of cash to pay off my mortgage. Wouldn’t holding that cash and keeping my mortgage help mitigate a sequence of returns risk? I understand I would have more fixed expenses, but I would also have much more cash. And should interest rates rise a little over the next five years, these funds could be held in safe investments also mitigating inflation risk?
I had always assumed I would pay off the mortgage, but am having second thoughts. Fortunately I have five years or so to decide!
Thanks for writing this. I think it nicely demonstrated the often missed (or ignored) concept of personal inflation. Unfortunately, it’s simply too difficult to run these calculations for everyone at an individual level and so the official measures of inflation only ever provide a consolidated overview of what the demographic as a whole is experiencing.
When it comes to the impact of inflation on debts (or fixed nominal expenditure). I suppose the deflationary effect comes about due to the fact that the principal of the debt is a fixed amount, notwithstanding that there is interest to be paid on that principal. I wonder if the same still applies to incredibly high interest debt (e.g. payday loans, certain credit cards). At what point does the snowball effect of such interest become so extreme that the debt as a whole (principal and interest) will no longer deflate away with time? Perhaps something to think about given the new low inflation environment we find ourselves in (not that I expect FI bloggers / FI blog readers to be dabbling with payday loans but you never know).
Two other aspects of inflation that may be interesting to explore:
1. whether we are always truly comparing like with like when we measure inflation. E.g. whilst a modern apple probably has similar properties to an apple from 15 years ago, the inflation rate of the cost of a mobile telephone over the last 15 years may not capture the fact that a modern mobile telephone has substantially more features and is a far more useful and sophisticated product than the mobile telephones from 15 years ago.
2. The way that we measure inflation skews the data towards ‘transience’. What do I mean by this? Say a house costs a $100k to purchase outright. In year 1 house prices experience an inflation rate of 100% (very concerning – far above target!). In years 2 and 3 houses experience an inflation rate of 0%, i.e. they remain unchanged. The transient annual way that we measure inflation captures the price increase in year 1 and then completely ignores the lasting effect of that price increase in years 2 and 3. This transient view of inflation ignores the fact that if wages / salaries didn’t increase by 100% over the 3 year timeframe in my example then people are permanently affected by the increase in house prices (unless and until their wages catch up). If you replace house prices with ‘rent’, ‘food’, ‘water’, ‘medicine’ you begin to see where the problem lies. The transient way that we collect and discuss inflation data may downplay the fact that inflation target overshoots by central banks may errode the spending power of people on a lasting basis.
HH
I can see how FIRE could allow one to lower his personal inflation rate. With a lot more free time, once can choose to travel in the offseason or shoulder season, take advantage of Sunday – Thursday rates, take more time to find better bargains on many consumer items, etc…
One more reason to FIRE.
Cheers!
-PoF
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Interesting article. Health care inflation is very concerning right now. Even vet care for pets is inflating. I think a fatFIRE is the best insurance against inflation and SOR.
I recently started my own series on stocks as an inflation hedge. I wish I had procrastinated more and first read this series by you two. It probably would have saved me a lot of time and made my posts more focused. But that cookie has already crumbled!
When you write more about inflation hedging, be sure to clearly define what you mean by a “hedge”. In my research, I found a lot of confusion around what exactly is a “good” versus “bad” hedge. My view is that stocks are a sporadic hedge against inflation (see my last two posts), which to me is a pretty “good” reason to hold stocks, considering their outstanding long-term historical returns. But others seem to think that makes stocks a “bad” hedge against inflation. They insist on a pretty strong positive correlation between returns and inflation before concluding that anything is a “good” hedge, which seems unrealistic to me.
Also, I found many articles and papers dated to around 2011 and 2012 on this subject. People were really worried back then that inflation was about to ramp up and ruin everyone’s real returns. There seems to be a similar atmosphere today, which is probably one of the reasons we all turned to the subject of inflation in the last few months. Funny thing is that inflation has remained mild in the last decade. All those worries in 2011 were for nothing. Who knows whether recent history is going to repeat itself tomorrow.
Like some others commenting here, I had never thought about the idea of a personal rate of inflation. Great choice for a new topic to cover!
Karl – never wish for more procrastination in the field of blogging! Heh heh
I will take a look at your posts thanks for letting me know. You make a good point on hedging. I agree, short term hedging or correlation can be important to investors that have to regularly mark to market. But for other investors like retirees they probably don’t care about the short term correlation and instead require a long term real return in excess of inflation.
Thanks for visiting
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Great discussion…proves the adage again…”personal finance is personal…”