Preface: The inflation-deflation debate is a favorite topic at dshort.com, one that today's guest contributor previously addressed in The 'Flation Debate. Today Edward Jaffe returns with a different analysis regarding inflation measures.

It is important to understand that many widely accepted metrics of current and historic economic and investment performance are flawed and lead to conclusions that certain parties wish us to arrive at. Like stepping on a scale that already has 73 lbs on it, proper calibration is essential to honest weight.

A quick visit to some websites of leading financial institutions lead us to calculators and other presentations where the viewer is told to utilize a "historic" number in order to project future inflation as best as one can. The numbers I have found range from 2.30% to 4.00%. Most sites use 3.00%.

A leading broker says that "inflation has averaged 3% over the past 80 years." Current financial panic aside, the last time inflation was honestly ~3% for any length of time was the 1960s. Are we really that in love with the idea of fooling ourselves?

For purposes of contemporary planning, looking at any pre-1971 data is absurd and misleading. Read more to see why. This is a short essay, not a book, so the time I can spend on the definition of inflation will have to be limited.

Oops! That last one is a problem. We are really using currency and calling it "money." This currency is not a storehouse of value; rather it is simply a medium of exchange. The popular notion that creating more "money" makes prices go up is generally valid — as is the idea that skyrocketing prices represent "inflation" even if the observer is not entirely sure what M1, M2, M3, MZM and TMS are up to lately (see the handy explanation here). We generally measure symptoms rather than look at the causes, which would be excessively painful.

There are a variety of "inflation" causes and much variation of "inflation" symptoms and manifestations. In a previous essay I focused on asset inflation and its connection to credit expansion. In this essay we are going to touch on studies of the general price level and other measures that relate to the "cost of living." The focus here is to determine how valid some of our "retirement" concepts and calculations are. There are countless plans, calculators, theories and promises that fundamentally rely on a level of inflation that bears little resemblance to our real history — despite their liberal use of the word "historic."

For further explanation of the chart above, visit dollardaze.org.

A casual look at the monetary aggregate mountain range should frighten anyone who has future obligations payable to him/her in nominal units of some currency (like an annuity). Once currencies are purely symbolic, central banks can create an environment of extreme expansion.

For someone seriously trying to determine future prices, an objective idea of past events and metrics would seem necessary. A good place to start is to ponder whether or not we are dealing with the same currency. After all, lots of things are called "dollars" including the currency of Zimbabwe.

The Historical Perspective

From the end of the Revolution until 1873 America saw much volatility in prices but little cumulative inflation. The purchasing power of the "dollar" was similar in 1875 and 1914 despite substantial volatility in between. That 1914 "dollar" is worth pennies today — so it seems rather silly to consider it the same currency.

The United States was on a fairly consistent gold standard from 1873 to 1913. The Public-Private Federal Reserve Bank was created in 1913. There was some price inflation and much credit/asset inflation during the "Roaring Twenties" and by 1933 the world was in the midst of the Great Depression. While many prices had collapsed along with commerce, the dollar was debased further when the US — and most of the nations of the world — abandoned the gold standard. There was much sovereign insolvency at the time — a phenomenon we are starting to notice today. Winning — not fighting — WWII ended the depression for the US.

It is instructive to think about inflation in the US as a series of eras:

• 1776-1873: Primitive banking. This period was characterized by "Free Banking" (many private instruments became worthless), volatility, disorder, little cumulative inflation in the modern sense.
  
  
• 1873-1913: Sound Money and a "Golden Era" (especially if you had money). There was a structural decline in most prices during this period which has led to some controversy amongst monetary scholars, as some think prices were pulled down by industrialization and massive increases in productivity — which would not actually be "deflation" OR problems with the gold supply and the lack of a bimetallic standard creating monetary contraction and true "deflation".
  
  
• 1913-1933: Boom to Bust. The imbalances created by WWI and the 1920s bubble created, with the assistance of the new FED, a collapse the world economy: inflation to deflation.
  
  
• 1933-1946: Depression and War. Most of the nations of the world abandon the gold standard in order to reflate collapsed economies, fulfill obligations and fund military activities and purchases.
  
  
• 1946-1971: Bretton Woods System. Countries fixed their exchange rates relative to the U.S. dollar. The U.S. promised to fix the price of gold at $35 per ounce. Fairly stable prices in the US — a period of relatively sound money and prosperity — especially for average Americans.
  
  
• 1971-2010: The Federal Reserve Note. The dollar becomes an "IOU Nothing" and is basically reduced to an irredeemable symbolic "ticket" with no par value ("Fiat Money"). Its purchasing power declined at an accelerated rate after 1971 and its value in the future could be anything.

There are many people who think that official economic metrics (BEA/BLS/FED/other) do a poor job of matching objective reality and furthermore that there are obvious political motives and possible long-term savings of billions if not trillions if "inflation adjusted" payments and interest on government debt can be keyed to lower inflation numbers. In areas like unemployment there are more useful numbers available (U6 = ~17%). But somehow only the "headline" number (U3 = ~10%) makes the headlines [See footnote].

Click for a larger image

Fortunately there is a firm that has made a scholarly effort to generate corrected results using the same basic data — essentially economic metrics ex-manipulation. That firm is Shadow Government Statistics and their work frequently appears as an alternate metric on this site. It a a subscription-based website, but much of the content is available to non-subscribers.

If we are going to think about what inflation might be like in the future, the Consumer Price Index (CPI) from 1971 until today would be your best-case scenario. Averaging in CPI before 1971 is a non-case scenario — as one would be comparing a society on gold/quasi-gold standard to complete fiat money. Also it is important to understand how important making a low-inflation case is to the sell-side of the financial product sales world. How can you be convinced to buy all those mutual funds (with sales loads) if returns are not above inflation?

There are actually three key issues for thinking about inflation and the future. One is selecting the time period for "historic inflation." The second is the accuracy of the official CPI (we are trying to avoid compounding dishonesty). The third issue is that many credible people see very-high inflation in the future as the only end game to global sovereign debt issues. This last issue won't be addressed here, but it is worth keeping in mind.

The Official CPI versus Shadow Government Statistics

We all know there was high inflation in the 1970s shortly after Nixon closed the gold window, ending convertibility between US dollars and gold. The Oil Embargo of 1973 exacerbated matters. We know that because the CPI was a reasonably reliable metric. According to SGS, statistical manipulation of the CPI began in the 1980s, making the issue of price analysis particularly confusing in the first decade of this millennium.

According to the Bureau of Labor Statistics (BLS), price inflation was tame during the first decade of the millennium. But SGS has another story to tell. When comparing these two metrics there a few things to keep in mind that don't reflect well on the conclusions offered by the BLS.

Increases in commodity prices were very substantial, especially energy (not shown). We import huge quantities of raw and finished goods in our mass-consuming economy. How could CPI price measures be so stable with commodity prices on such a tear? The drop in the value of the dollar and the updraft of commodity prices relate somewhat and make sense, but the CPI numbers don't. I invite everyone to review your check stubs and other costs from 2000-2010.

So official CPI 1970-2009 is around 4.5% (a long way from 2.3%) — but estimated SGS consumer price inflation for 1970-2009 is around 7.5%.

Calculating the Future

Now let's flash forward to 2030 and go shopping on a shopping trip with our ShadowStats currency calculator:

• $27.50 = 1 gallon of organic whole milk
• $15.00 = 1 pound red Holland peppers
• $17.00 = 1 pint Ben & Jerry's
• $150.00 = 1 gallon Vermont maple syrup
• $150,000.00 = 1 small AUDI
• $1200.00 = 1 hour with Vermont lawyer
• $2400.00 = 1 hour with NYC lawyer
• $8.50 = 1 can of Campbell's cream of celery soup (10 cents in 1970)

We are not going back to a gold standard from where we are now — not without a Total System Reset.