The Politics of Inflation

The U.S. Treasuries markets are predicting a lower average rate of inflation in the future 5, 7, 10 and 20 years than we have experienced over the past 15 years. The chart below shows the past experience and future expectation.

The trailing 15-year average CPI was 2.64% and the predicted 5-year future average inflation is 2.23%. The predicted 20-year future inflation, based on CPI, is 2.46%. [click to enlarge]

The table below shows the predicted future inflation for the periods 5, 7 10, and 20 years, along with the factors used to calculate the prediction. [click to enlarge]

The CMT (Constant Maturity Treasuries) rate is calculated from the yield curve for Treasury bonds other than TIPS.

The R-CMT (Real Constant Maturity Treasuries) rate is calculated from the yield curve for TIPS (Treasury Inflation-Protected Securities)

Treasury Inflation-Protected Securities, also known as TIPS, are securities whose principal is tied to the Consumer Price Index. With inflation, the principal increases. With deflation, it decreases. When the security matures, the U.S. Treasury pays the original or adjusted principal, whichever is greater. TIPS pay interest every six months, based on a fixed rate applied to the adjusted principal. Specifically, each interest payment is calculated by multiplying the adjusted principal by one-half the interest rate. The principal adjustment is taxable as credited each year, but not paid until maturity. Holding of TIPS in tax deferred accounts is the best option to avoid taxation of unrealized gains.

The predicted rate of inflation for a given period of time, according to the collective judgment of U.S. Treasury debt purchasers, is calculated by subtracting the "real" yield on constant maturity TIPS for the period in question from the yield on non-TIPS constant maturity Treasuries for the same period.

Put differently, TIPs have no CPI inflation risk and other Treasury bonds have full CPI inflation risk. Both have identical credit risk. By using constant maturities in the calculation, they have identical risk associated with time, except for inflation. Therefore, the difference in their yields to maturity is the inflation risk associated with the non-TIPS Treasury bonds.

There is one possible fly in the ointment however -- that being political risk. Since the Federal government is issuing the inflation-protected securities (meaning that have to repay the loans they receive in inflated amounts due to inflation), and since they are also in control of the definition and measure of inflation, there may be strong and increasing political pressure to NOT update CPI measurement if that updating were to increase the Federal budget and tax burden. We don't know how serious that risk is, but to deny that it exists is pure ostrich head in the sand thinking.

For example, we wonder sometimes what planet the government is using to take inflation sample data. The world the author lives in doesn't seem to be experiencing the same inflation forces as the CPI measures, at least not for property taxes, medical insurance, heating oil, gasoline, restaurant tabs, cable TV invoices, movie theater tickets, and many other things.

In any event, you can take your own guess about inflation, or read a poll of economists, or project the past into the future, or rely on the collective judgment to debt buyers to make your own predictions about inflation.

However you come up with a figure, you need a figure to plan elements of your portfolio design with respect to expected returns and the hurdle rates you need to meet any withdrawal requirements and to assure that you do not outlive your investments.

Some ETFs that relate to the bond story above are:

• IEI 3-7 Year Treasuries
• TLH 10-20 Year Treasuries
• TLT 20+ Year Treasuries
• TIP 3-25 Year TIPS Treasuries (av. maturity ~ 10 Years)