Is the Inflation rate really what is published ?

January 27, 2011

To our dear friends and clients,

Over the past several years I have often wondered what the true inflation rate is in Canada and the US. The US has had some significant compression in hard assets due to the compression of housing prices over the last number of years however Canada has had no or very little decline in housing prices except in Alberta. Many raw material prices however have increased very drastically starting with oil from $10 to $12 per barrel 10 or 12 years ago to food agricultural commodities, services, real estate and the list continues. An increase in inflation results in higher bond yields and could have an impact on your bond portfolio or your preferred shares. A recent article on Marketwatch has confirmed my suspicion even in the US. Please read it on Marketwatch directly at:

http://www.marketwatch.com/story/why-you-cant-trust-the-inflation-numbers-2011-01-26-1137490

or as the attachment to our e-mail (please ignore the advertisement on top – we believe it should be the Schwaben Banner and not Putnam – a bit of humor).

Several economists have increased their long term bond yield forecasts today which is an indication that higher inflation is on the horizon.

My partner, Bernd Henseler, has done a more extensive review of this phenomenon and has come up with the following preliminary conclusion:

Inflation: Do you live in an average Canadian household?

If yes, then the latest Consumer Price Index (CPI) data might be relevant to you. If not, you might feel that the latest annual increase in the CPI of 2.4% is does not reflect your cost of goods and will likely indicate a lower increase than what you may be experiencing.

Firstly, what is the CPI? The CPI measures the price development of a representative shopping basket of 600 goods and services that the average household consumes. The basket is adjusted throughout time to reflect changing consumer behaviour.

But secondly, what is an average Canadian household? The average household has a total annual income of around $71,277 and after taxes and pension savings it has expenditures of $50,734. Expenditures are spent on:

Category Percentage Dollar Amount
Food 14.3% $7,262
Shelter/Housing 27.8% $14,095
Household operation, furnishing and equipment 10.5% $5,324
Clothing and footwear 5.6% $2,841
Transportation 19.2% $9,753
Health and personal care 6.3% $3,204
Recreation, Education, Reading 12.8% $6,493
Tobacco, alcohol and games of chance 3.5% $1,761

Source: Statistics Canada 2009

Not surprisingly the CPI basket that is used has a similar breakdown and weighting.

And, do you feel represented by this breakdown? Where are the soaring energy cost, what about the latest increases in tuitions, nobody noticed the rising food or commodity prices? HST?

Maybe, the simple answer is you are not an average Canadian household, but you are an average household in Ontario. Households in Ontario earn more than the national average and have general higher costs for housing and transportation. The CPI figure for Ontario is 3.3% and therefore 37.5% higher than the Canadian CPI figure of 2.4% (see Table 2). If you are living in Ontario, that lets you definitely feel a bit more pinched for your money.

Category Canada 

CPI from Dec 2009 to Dec 2010

Ontario 

CPI from Dec 2009 to Dec 2010

Food 1.7% 1.5%
Shelter/Housing 2.7% 4.1%
Household operation, furnishing and equipment 1.7% 2.2%
Clothing and footwear -2.0% -0.9%
Transportation 4.9% 6.2%
Health and personal care 2.3% 4.1%
Recreation, Education, Reading 1.1% 2.2%
Tobacco and alcohol 2.6% 3.8%
Overall CPI 2.4% 3.3%
All items excluding food 2.6% 3.7%
All items excluding energy 1.7% 2.3%
Energy 10.5% 15.6%

Table 2: Annual CPI for Canada and Ontario, Source: Statistics Canada

Another reason might be that your shopping basket is not equivalent to the average Canadian and therefore you feel that prices have increased. For example your households owns two cars instead of one, then you will be more aware of changes in energy prices. In Canada energy prices increased by 10.5% and in Ontario by 15.6% over the past year. In Ontario, energy prices added a full percentage point to the CPI. Without increases in energy the CPI would have been only 2.3% instead of 3.3%.

What about substitution of goods that you have purchased in the past, but now change to new more expensive items? For example, haven’t we used in past simple cell phones just to call people. Now, we have the latest I Phone or smart phone including data plan and many other expensive add ons.

What about the other big news items that food and commodity prices increased, e.g. vegetable products increased by 21.9% and animal products increased by 5.1% in the last year. But the CPI for food increased only by 1.7%. It seems that producer have not yet fully passed down the higher cost for raw material to the consumer, because of a competitive environment. However, if the prices will stay high, producer will eventually pass these higher costs on to the conumer. Just yesterday, McDonalds announced that it considers increasing the prices of Big Macs because of higher food prices.

The same will hold true over time for other commodity prices that producers will pass through to the consumer.

The CPI reflects only past price changes. What are other items that could cause inflation to rise in the future?

–       Sustained higher commodity prices that will be passed on the consumer

–       After the recovery of the recession unions will ask for higher wages, thereby  increasing production costs

–       Imported inflation. China as world manufacturer faces higher labour and raw material cost, that increase the cost of imported goods purchased in Canada.

–       Higher interest rates will lead to higher mortgage rates

Going forward the Canadian consumer will face several factors that could increase inflation over the next couple of years on an overall level. However, as we established, CPI data might not apply to your household, as you may not be an average Canadian household. Therefore your choices will affect your personal perceived inflation rate. Of course, you could create your own deflation, by only shopping at discount stores, selling your car, canned food instead of fresh food, using coupons and not buying the latest gadget. But is that fun?

Look out for inflation, possibly more than most expect, and review your investment portfolio.

Should you wish to discuss this further or would like to review your portfolio with us please call us at 416.572.2265.

Bernd Henseler                                                           Albrecht Weller

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