WEATHER IN LINCOLN COUNTY


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How do economists measure inflation, and why does it matter to investors?

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Duane J. Silbernagel
Financial Advisor
Waddell & Reed

How do economists measure inflation, and why does it matter to investors?
Provided By: Duane J. Silbernagel

The Federal Open Market Committee (FOMC) adjusts interest rates to help keep inflation near a 2% target. The FOMC’s preferred measure of inflation is the Price Index for Personal Consumption Expenditures (PCE), primarily because it covers a broad range of prices and picks up shifts in consumer behavior. The Fed also focuses on core inflation measures, which strip out volatile food and energy categories that are less likely to respond to monetary policy.

The typical American might be more familiar with the Consumer Price Index (CPI), which was the Fed’s favorite inflation gauge until 2012. The Consumer Price Index for All Urban Consumers (CPI-U) is used to determine cost-of-living adjustments for federal income taxes and Social Security.

The CPI only measures the prices that consumers actually pay for a fixed basket of goods, whereas the PCE tracks the prices of everything that is consumed, regardless of who pays. For example, the CPI includes a patient’s out-of-pocket costs for a doctor’s visit, while the PCE considers the total charge billed to insurance companies, the government, and the patient.

The PCE methodology uses current and past expenditures to adjust category weights, capturing consumers’ tendency to substitute less expensive goods for more expensive items. The weighting of CPI categories is only adjusted every two years, so the index does not respond quickly to changes in consumer spending habits, but it provides a good comparison of prices over time.

According to the CPI, inflation rose 2.1% in 2016 — right in line with the 20-year average of 2.13%.1 This level of inflation may not be a big strain on the family budget, but even moderate inflation can have a negative impact on the purchasing power of fixed-income investments. For example, a hypothetical investment earning 5% annually would have a “real return” of only 3% during a period of 2% annual inflation.

Of course, if inflation picks up speed, it could become a more pressing concern for consumers and investors.

1 U.S. Bureau of Labor Statistics, 2017 (data through December 2016)

How do TIPS help fight inflation?

One way to help protect your portfolio against a sudden spike in inflation is by investing in Treasury Inflation-Protected Securities (TIPS).

TIPS are guaranteed by the federal government as to the timely payment of principal and interest. They are sold in $100 increments and available in maturities of 5, 10, and 30 years. The principal is automatically adjusted twice a year to match any increases or decreases in the Consumer Price Index (CPI). If the CPI moves up or down, the Treasury recalculates your principal.

A fixed rate of interest is paid twice a year based on the current principal, so the amount of interest may also fluctuate. Thus, you are trading the certainty of knowing exactly how much interest you’ll receive for the assurance that your investment will maintain its purchasing power over time.

TIPS pay lower interest rates than equivalent Treasury securities that don’t adjust for inflation. The difference between the yield of nominal bonds and inflation-linked bonds with similar maturities is called the breakeven inflation rate. It is the cost for inflation protection and a market-based measure of expected inflation. If you hold TIPS to maturity, you will receive the greater of the inflation-adjusted principal or the amount of your original investment; this provides the benefit of keeping up with inflation while protecting against deflation. Considering that there has been some inflation every year over the past 60 years, the principal of TIPS held to maturity is likely to be higher than when they were purchased.1

The return and principal value of TIPS on the secondary market fluctuate with market conditions. If not held to maturity, TIPS may be worth more or less than their original value. They are also sensitive to movements in interest rates. When interest rates rise, the value of existing TIPS will typically fall. Because headline CPI includes food and energy prices, TIPS can also be affected by volatile oil prices.

Unless you own TIPS in a tax-deferred account, you must pay federal income tax each year on the interest income plus any increase in principal, even though you won’t receive that money until they mature.

1 U.S. Bureau of Labor Statistics, 2017 (data through December 2016)

I hope you found this beneficial and informational. For more information about me and my services, visit my website:
www.duane.wrfa.com
Thank you for your interest.

Duane Silbernagel is a Financial Advisor in Lincoln City, Oregon offering securities through Waddell & Reed, Inc., Member FINRA and SIPC. He can be reached at (541) 614-1322 or via email at DSilbernagel@wradvisors.com. 
This article is meant to be general in nature and should not be construed as investment or financial advice related to your personal situation. The article was written by an independent third party, Broadridge Investor Communication Solutions, Inc. (Copyright

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