What is Money Illusion?
Let's imagine that you could put yourself into suspended animation for a hundred years. Here's a question: if you could put your money into just one asset what would it be?
If your answer was "cash in the bank" then you would almost certainly be in for a nasty shock when you awake in the 22nd century. This is because of the effect of inflation: over time the cost of goods and services drifts upwards. Or, looked at another way, the buying power of money decreases.
So let's assume that inflation over the last century is repeated over the next and see what we might expect.
A 22nd Century Snack
As you are reanimated you are delighted to hear from your free personal robot that, thanks to the miracle of compound interest, you are a millionaire almost twice over. Rates averaged 3% and your life savings of £100,000 are now worth £1.92 million.
On hearing this news you decide that you are feeling a bit peckish. So you tell your helper robot that you would like a loaf of bread. In moments your loaf arrives by drone delivery and the robot tells you it cost £94!
You can't eat bread on its own, so you nervously order 250g of Cheddar which would have cost £1.75 in 2017. The robot hands you the cheese and tells you it costs £157.
You are so shocked that you decide a cup of tea would be in order. Fortunately, being British, you brought some teabags with you (just in case). But you still need milk. This time you ask the price before you order, and it turns out that four pints sets will set you back £61.
Overall the cost of living in 2117 turns out to be over a hundred times higher than in 2017. A basic standard of living that would have cost £1,000 per month in 2017 will cost you £106,000 per month in a century. You millions will last less than two years even if you adopt a frugal lifestyle.
How To Measure Inflation
Inflation is so important that it is an official statistic produced by almost every country. The way it is measured is to produce an ever-changing basket of goods consumed by the typical consumer in a country. As technology and lifestyles change the basket has to change. There are some universal things we require to survive: food, drink, clothing, shelter, transportation. Beyond subsistence most of us want some form of entertainment, so most households have at least one flat screen television, internet access, mobile phones...
Somebody has to be in charge of measuring the cost of prices and the contents of the consumption basket and in the UK this is the Office for National Statistics (ONS). They have a great interactive page so you can explore the history of UK consumption habits, ranging from corned beef in the 1940s to microwave rice, coffee pods and computer game downloads in 2016.
Once the contents of the basket are decided they are frozen for a year. Then they are updated based on surveys by the ONS, but also using feedback from the price collectors employed to regularly ferret out the hundreds of prices in the consumption basket.
The prices of items in the basket are collected then weighted based on their share of typical consumption and combined into a Consumer Price Index (CPI). The version that also includes owner-occupied housing costs is called CPIH. Weights vary widely across consumption categories, for example in 2017 the CPIH weighting for "Housing, water, electricity, gas and other fuels" was largest, making up almost 30% of the basket. Clothing and footwear made up just 0.6% (see the weights here).
Given the importance of inflation we seldom factor it into our financial plans or decisions. For example if you are trying to negotiate a wage rise what was the last time you mentioned CPI inflation? Did the conversation run along these lines:
Your Boss: "Your performance has been great this year so we're giving you a 2% raise."
You: "But the latest release from the ONS shows that CPIH, which I believe as a homeowner is most relevant for my family's consumption expenditure as it includes the cost of owner occupier housing costs, is above 3%. That means that the nominal wage rise you just quoted as a nominal rate is negative in real terms. So in fact you are cutting my salary in real terms."
No? Well, it should.
So to arm you a good approximation for working out real rates (adjusted for inflation) from nominal rates (not adjusted for inflation) is to simply subtract:
Real Rate = Nominal Rate - CPI rate
This is an approximation because compounding means that the numbers aren't exactly additive, but they're not far off.
In a study on money illusion (by Shafir, Diamond and Tversky in 1997) they presented two fictional cases:
- Ann: Starting salary $30,000, no inflation in first year, 2% raise in second year
- Barbara: Starting salary $30,000, 4% inflation in first year, 5% rise in second year.
They found that most participants (71%) correctly spotted that in economic terms Ann was doing better, as in real terms she had gained 2% while Barbara was only 1% better off. However when judging happiness the vast majority chose Barbara (64%).
They also found that only when contracts were framed in a specific way would people prefer the inflation-adjusted option.
This may explain why almost no work contracts mention inflation at all.
Inflation Linked Investments
Employment contracts seldom mention inflation and the same is true of financial assets like bonds. Some bonds have a lifetime measured in decades and their value will be heavily influenced by inflation over such long periods of time. And yet very few bonds have their value tied to inflation.
The same is true of the Exchange Traded Fund (ETF) market. These are traded like shares, but give investors the ability to effectively buy a tiny slice of a whole share index, like the FTSE 100, or whole bond index like the Barclays US Aggregate Bond Index. The price of the ETF tracks its index. Again, of the thousands of ETFs that are available to UK investors only a handful give inflation protection.
When we think about house prices we often hear grandparents saying how they bought their house for a few thousand pounds in the sixties, and the incredible rate of return over the intervening period. But what they fail to do is report return in real terms which makes the price appreciation much less impressive. Once you factor in the cost of renovation and upkeep the idea of property being a sure way of beating inflation is not so convincing. Based on long-term US data (often quoted by Robert Shiller) investments in the stock market where we re-invest dividend payments would probably provide a better long-term return over several decades. Plus you don't have to re-paint a share or fix its central heating.
How To Dispel Money Illusion
The best way to conquer money illusion is to always consider real returns for any contract, salary, or investment that is over a few years in length. This is harder than it sounds. Secondly you have to know the rate of increase of inflation, which you can do easily, and for free, by looking at the ONS website. And finally you may want to know what experts think will happen to inflation in the future.
The Bank of England has to set monetary policy, which is the level of interest rates, in order to keep inflation in check. If they think inflation will increase they raise rates, if they think there is a danger of deflation they lower rates. The difficulty they face is that the effect of interest rates on the economy and on inflation take several years. So their job is rather like steering a supertanker. They have to think ahead. This means they can't rely on inflation today. They also have to estimate where inflation will be in the future. They publish this, and much more, in their hefty inflation report which they publish four times each year.
Notice how these inflation projections are fan charts. Because the future is uncertain, and forecasters would be the first to concede that all inflation models are imperfect, they have to show the uncertainty in the forecast. The most likely path of inflation according to the Bank's model is in deep red, which captures the future with a 30% probability, but they also admit that it is quite likely that inflation will fall outside this corridor into the lighter coloured bands or beyond. So although you should start in the knowledge that these forecasts are often wrong, you will still be able to slap this report on your boss's desk when it's raise time and argue your case for a pay rise using the Bank of England's inflation fan charts. Good luck!
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