Seeking Alpha
What is your profession? ×
Long-term horizon
Profile| Send Message|
( followers)

Many investors are worried about inflation. As a result, some are considering buying inflation indexed bonds and other inflation protected investment vehicles issued by banks and insurers. Treasury Inflation-Protected Securities (TIPS), for example, are marketable securities whose principal is adjusted by changes in the Consumer Price Index (CPI). With inflation (a rise in the index), the principal increases. With a deflation (a drop in the index), the principal decreases. That means that the interest rate remains fixed, but the actual money paid out increases or decreases depending on how the rate of inflation has affected the adjusted principal.

Many banks and insurers, from JP Morgan (NYSE:JPM) to Hartford Insurance Co. (NYSE:HIG) offer other "inflation protected" investment vehicles that are structured somewhat differently. The common element in all of the offerings, however, is a promise that buyers will be protected against inflation, with the value of the investment and/or the interest paid on it determined by changes in the CPI. This official number is calculated by the Bureau of Labor Statistics division of the U.S. Commerce Department.

The official CPI, unfortunately, is at odds with the perception by much of the public that prices are rising very quickly. The most recent Commerce Department CPI release claims the general rate of consumer inflation is running at about 3.6% year over year. Meanwhile, many people report that their personal experience is that prices are up, year over year, by considerably more. The disconnect between official numbers, and public perception may become more severe.

New legislation is being introduced in Congress. We will discuss that later, but the new legislation, if passed, will cause the inflation rate, as computed by the government, to drop for various reasons. For now, let us discuss the two most important and controversial statistical methods used the Bureau of Labor Statistics that many people complain is adversely affecting the accuracy of the CPI. These are known as "hedonic quality adjustment" and “product substitution weighting.” The two techniques profoundly affect calculation of the Consumer Price Index.

According to the US Commerce Department website, hedonic quality adjustment means that government statisticians reduce the price of various goods that they later plug into the inflation calculation in order to account for product improvements. To understand this concept, let's use a theoretical example. Let's say, the Chevrolet Malibu (NYSE:GM) is a part of a basket of goods used, in 2010, to create the official CPI. GM introduces a 2011 model that has a quieter engine, a redesigned suspension, and more foam padding on the dashboard. The base model car cost an average of $18,500 in 2010. In 2011, people pay an average of $19,600 because the manufacturer's suggested retail price goes up. The Commerce Department does not use the $19,600 number. Instead, it considers how much the improvements are worth. That is called the "hedonic value" of the changes. Let's say that the government concludes that the improvements are "worth" a "hedonic" $2,000. The statisticians plug $17,600 into their formula as the cost of a Chevrolet Malibu, not $19,600.

"Product substitution" is another method used by government statisticians. According to the Commerce Department website (pdf), the CPI, if calculated as a fixed-weighted index, overstates changes in the cost-of-living because consumers can substitute toward categories of goods and services whose relative prices have fallen. Government statisticians say that the basket of goods must be dynamically changed to account for the changes in behavior. Let's say, for example, that fillet mignon is part of the CPI basket of goods in 2010, when its price per pound is $13. Then, by the end of 2011, fillet mignon skyrockets to $25 per lb. The government statisticians conclude that people will eat more hamburger because it has become relatively cheaper in relation to fillet mignon than it was the year before. So, according to the government, the true cost of living must include a heavier weighting of hamburger meat rather than fillet mignon. This is because that is what people are buying in 2011. The statisticians plug $3 per pound in place of $25 per pound into the CPI calculation.

The calculation of the CPI inflation rate did not always include these techniques. Back in the 1970s and early 1980s, a fixed basket of goods was used, throughout administrations headed by both Republicans and Democrats. During the 1970s, America experienced what many economists now refer to as the Great Inflation. The CPI soared to the double digits using the government's then-traditional static basket of goods. That was all changed in 1982, when a more dynamic formula, including these new statistical techniques, began to be introduced. Yet, if we apply the 1980s formula to the period immediately prior to the World Financial Crisis of 2008, we would find that the CPI was soaring into the mid-double digits, according to economist John Williams. Instead, with new hedonics and product substitution formulas, the government claimed that inflation was in the low single digits.

More formula changes are on the horizon. Vice President Joseph Biden heads a budget cutting committee, and the committee says it has a plan to reduce government expenses by a $220 billion, over ten years, by making the CPI calculation "more accurate." Savings will be achieved on Social Security cost of living increases, Medicare reimbursements, TIPs interest servicing expense, and a host of other government expenses tied to inflation. All are indexed to the official CPI, and all these expenses will go more slowly if the reported level of the consumer price index does down.

The NASDAQ news feed reports Congressional aides as having said these new proposals will help the CPI reflect "how people change their spending patterns when prices increase." The new legislation will require the BLS to consider the fact that people use less of things that rise quickly in price. For example, let’s say people shift to buying very small fuel efficient cars because they cannot afford the price of gasoline. People are forced to use a lesser volume and weight of gasoline and the government argues that, as a result, the overall inflation rate has gone down. If and when this new legislation becomes law, the BLS will dynamically change the CPI formula to change the weighting of various goods and services, reducing the percentage assigned to goods that rise in price, and increasing the percentage assigned to goods that fall or are static.

Investors who are considering the idea of buying “inflation indexed” investments must ask themselves something very simple. Does this make sense? Is hedonic and/or product substitution a correct and accurate way to figure out what the price increases in the economy are? If, for example, the population can't afford good cuts of beef anymore, and must substitute bad cuts, can it be said that the cost of living is not rising, or has gone down? As to proposed changes to the CPI, is it accurate to claim that consumers are not experiencing inflation simply because the price of gasoline is forcing them to use less and they are buying smaller cars in order to do so?

As we have discussed, the CPI profoundly affects buyers of "inflation protected" securities. It affects both the sum you are paid when your TIPS bond matures and the amount of interest that a TIPS pays you every six months. That is because interest payments and the periodic adjustment to principle are based upon the rate of inflation, as calculated by the US. Commerce Department. The inflation rate is not calculated by the intuitive formula that existed prior to 1982, which may be the method by which a lot of people perceive inflation rates around them. If the CPI is inaccurately understating the rate of inflation investors will lose both part of the principal and part of the interest they were supposed to receive.

In terms of actionable investment advice one thing should be emphasized. Because of the way the government is now calculating the CPI, and the further changes being proposed, buyers of TIPS bonds and other CPI indexed securities need to be very wary. They may be setting themselves up for significant losses. In the opinion of this writer, the CPI calculation appears to be inaccurate. As a result, such investments may not be appropriate inflation hedges.

So-called "I bonds," sold many years ago, had a substantial base interest rate of up to 3% that helped to partially offset the possible inaccuracy of the current CPI calculation formula. New I-bonds, however, don’t carry this benefit. Most supposedly inflation protected investments are devoid of a substantial base rate. Because of that, they are no longer a wise place to invest funds.

If you are seeking protection against inflation, you are better served by investing in precious metals or commodities. These types of investments are very volatile. The volatility and the roller-coaster price wagon that it brings with it scares conservative investors. However, with some PMs and commodities likely to take a substantial dip when and if the Fed really stops printing money, an excellent time to buy will be created, as many hedge funds and other fast-money types exit the field. If we do have substantial amounts of inflation, as famed investors Jim Rogers, Bill Gross and others believe, PMs and commodities will serve as a store of value for your assets. They should be bought on any big dip.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.