Dear Mr. Berko:

You wrote a good article on how changes in the money supply can cause an increase or decrease in the price of goods and services, which helped me understand how monetary policy works. What I don’t understand is if inflation is 3 percent, why it costs my mom and dad more to live than it costs me.

My dad is 69 and lives on a pension and Social Security. He had no trouble maintaining his household when he retired seven years ago. In the past two or three years, he insists that costs of things have really gone up. I haven’t found that to be the case. He says he is spending much more money on the same things he was buying seven years ago. Can you explain this?

D.D., Oklahoma City

Dear D.D.:

Most people don’t know that there are three tiers of inflation. The federal government only admits to “one size fits all.” Understanding the three inflations will help you understand why your dad is having such a tough time.

The first tier of inflation is called government inflation. This is a number used by the House of Representatives, Senate and the executive branch to formulate economic policies.

Back in 1991, former Democratic Speaker of the House Thomas P. “Tip” O’Neill observed, “The White House is employing voodoo mathematics again.” Today, the federal government tells us that inflation is 3 percent, and I trust those government numbers about as much as a laboratory rat would trust a research biologist.

But if the Gallup, Roper or Harris organizations conducted a poll, the consensus would indicate that most Americans believe the 3 percent number is a fairy tale.

The second tier of inflation is called workers’ inflation. This is where the costs of goods and services increase at a rate that exceeds your increase in wages. Certainly the prices of meat, bananas, cheese, etc., have risen more than 3 percent.

The costs of a new home; auto tires; a house call from an electrician or plumber; college tuition; municipal and state taxes; prescription drugs; auto, home and health insurance; car repairs; utilities (cable, phone, power, garbage); prescription glasses, etc., have increased substantially more than wages. Workers’ inflation is easily 6 percent to 8 percent this year.

The last inflation tier is retiree inflation, and this is why your dad is having a tougher time than you. Simply defined, this is where the cost of things increase more than the retiree’s increase in income. Most retirees depend upon Social Security, pensions and investments for their incomes. As rates on certificates of deposit, money market accounts, corporate bonds, preferred stocks, etc., decline, they get double-whammied. This tier may be the cruelest of all.

The retiree has many of the same fixed living costs as the worker, but his unearned income has fallen sharply. Sadly, he spends a greater proportion of his income on necessities that have experienced the largest increases in price.

Three years ago, he was earning 6 percent on CDs; money market accounts were paying 3 percent; short-term Treasuries were yielding 5 percent. Today, the yields on these instruments are at about half those levels.

In other instances, where the retiree has lost money in the market, he has fewer dollars to invest and the decline in his income becomes even worse. Retiree inflation is easily 10 percent to 12 percent.

Many observers believe that the current rate of inflation is under-exaggerated and believe that within the next few years, the inflation rate as computed by the Bureau of Labor Statistics is likely explode and exceed 6 percent or 7 percent. They cite record-high federal deficits (more than $455 billion in 2003) that must be funded with new issues of U.S. Treasury bonds.

They cite record-high state deficits (California has a $38 billion dollar shortfall) that must be funded with billions of dollars of newly issued municipal bonds. It’s estimated that the states may have to raise more than $90 billion of new money this year to pay for last year’s living expenses.   We’re talking about a half-trillion dollars of new money that has to be printed by the Treasury just to fund government expenditures. Add an estimated $200 billion for new corporate debt, and pretty soon we’re talking real money.   Funding this shortfall puts an enormous strain on financial markets, which could force interest rates back up again. This could create a sustained spike in the inflation rate that would be a nightmare for the White House.

Please address your financial questions to Malcolm Berko, P.O. Box 1416, Boca Raton, Fla. 33429 or e-mail him at malber@adelphia.net.