TIPS

“Even the shoe-shine boy is” worried about inflation (a prelude to my next post), and thankfully, the United States’ government has just the security to provide the protection we need. They are called Treasury Inflation Protected Securities or “TIPS”.

About 5 years ago I was working at GE handling settlements for corporate and government bonds. One day Mary (my boss’s boss) put a pamphlet on my desk about a new form of debt being issued by the Treasury that was indexed to “inflation”. The initial par value (the amount originally lent to the government, on which a fixed rate of interest is paid), is adjusted semiannually to reflect changes in the Consumer Price Index (CPI). Basically, the government promises to pay you a fixed rate of interest on a principle amount that is adjusted to reflect “inflation.” A quick example will drive this home… Let’s assume that 1.) I lend the government $100 by purchasing a $100 TIPS at 2.5%, and 2.) During the year the Consumer Price Index increases by a frightening 10% (yikes!). In this scenario, the government will owe me $2.75 in interest ($100 X 110% X 2.5%) and the new principle balance owed to me at maturity would be $110. According to the CPI, my money buys 10% less now than it did last year; but that's ok, because I have 10% more of it coming to me at maturity – hence “inflation” protection. Why all the quotation marks?

As the aspiring young patriotic pessimist that I was, I wound up thinking about the meaning of TIPS from the perspective of the US Government and the taxpayers they represent.
As I was reading the pamphlet, oil had crept up to a 20-year high of $50/barrel, the dollar had been falling steadily for 3 years, the fed's target interest rate was FINALLY creeping up past 2% from its 1% lows, and it had been 18 months since Bush declared victory in Iraq.

Although it did not occur to me at the time; it was probably about this point when our executive branch decided to take a break from foreign policy for a quick look at our economic prognosis. Military/intelligence spending was paramount, healthcare debts were ballooning, the current account was grossly negative, and social security was a looming disaster. At some point soon, we were going to have to borrow some money… lots of it; but with such a weak dollar (low demand for treasuries), how would we do it? What if we couldnt sell more treasuries without having to entice lenders with higher interest rates? Raising interest rates would prick the housing bubble and send our economy into depression! “Not on my watch”, said George, and thankfully, the treasury already had a plan to back him up.

The government could no longer borrow for long periods at a low fixed rate, so they decided (like any borrow might) to go for an adjustable rate. An adjustable borrowing takes interest rate risk off the lender’s shoulders and places it over the head of the borrower (as many house-flippers now know).

…For the sake of accuracy, I have to mention that all treasury securities are technically adjustable rate borrowings since they must be refinanced at the prevailing market rate of interest when the securities mature. In fact, over 30% of our government’s debt (Treasury Bills) need to be refinanced each year (or less)! Longer term debt (Notes and Bonds) are refinanced (or "adjusted") every 3, 5, 7, 10, or even 30 years, and are a much more attractive way for our government to borrow IF they can find people willing to lend, and assume the interest rate risk...

With TIPS securities, the government was able to convince investors to lend $530 billion for longer periods (5, 10, 20, and 30 years) by promising to protect the lender’s purchasing power from the wrath of “inflation”. The government would pay a lower fixed rate of interest than other debt offerings, but would adjust the principle balance by changes in the Consumer Price Index.

Now here's the genius part: Inflation and “changes in the Consumer Price Index” are two very different things. The Consumer Price Index is calculated by the US government's Bureau of Labor Statistics based on rules that can change. In other words, the US government borrows at an adjustable rate… but THEY decide the rate(!) …To an extent.

So the government now has a new goal. To understate (or simply control …for now) the Consumer Price Index - shortchanging their lenders, and managing their cost of debt. How can they do it?

One way is to make subjective CPI adjustments for product quality. The rationale is this; if a new Ford Taurus cost $10,000 in 1985, and $20,000 in 1995, that may seem like a lot of inflation. But the 1995 model has an automatic transmission, traction control, AND a CD player! So the basket of goods that make up the consumer price index is changed to reflect this quality increase; the $10,000 ‘85 Ford Taurus is removed from the basket of average consumer goods and replaced by a $10,000 ‘95 Honda Civic (which has a manual transmission, no traction control and no CD player (just like our beat up old ‘85 Ford). So alas, the portion of the CPI index that is supposed to track automobile price increases registers a tame 0% “inflation” from 1985 to 1995. Does that really reflect reality? While the CPI is happy to downgrade (make shopping cart substitutions), the American family generally is not.

So that’s a start, but what about the price of homes? My parents bought the house I grew up in for $70,000 and now it’s worth over $400,000! That’s MASSIVE inflation and it’s bound to show up in the CPI, right? Wrong! In order to remove the predicted effects of an inflationary housing bubble it was decided in 1983 that the price of housing should be included in the CPI based NOT on the price of the home but instead based on something called “Owners’ Equivalent Rent.” Owners Equivalent Rent is the answer to the following question posed to a random sampling of American homeowners by the Bureau of Labor Statistics: “If you were to rent out your home today, how much could you get for it?” So let’s say I buy my parents home today for $400,000… With a 6% mortgage and $40,000 down, my monthly payments as a homeowner would be about $3,250 per month ($2,150 mortgage + $500 property taxes + $200 maintenance + $200 utilities). My “Owners Equivalent Rent” would be a measly $1,700!

“Owners’ Equivalent Rent” not only evades a housing bubble’s inflationary effect on CPI, it also provides downward pressure on prices once the housing boom is over, since an oversupply of houses will certainly decrease rental prices, even as other areas of the economy experience price inflation.

Before you run home and get your torches and pitchforks I should mention that this calculation choice is well grounded in economic theory as a way of separating the investment value of a home from its shelter value. After all, the CPI is attempting to measure the cost of shelter, not the cost of speculation… But rental equivalence (shelter value) is still directly related to price by capitalization rates (financing cost), and thus not truly separated from the speculative trends ~ This is out of scope, and I digress.

The point is, it’s very hard to accurately reflect global price increases with one number, no matter how complex the polling and calculation. The CPI does attempt to be “quality of life neutral” but it’s not perfect, especially in turbulent markets. Although manipulations are not yet blatant and irrational, the motivation is there, and the world is watching.

What will happen? It all depends on how the government finances the next few trillion that it needs.

If they use mostly TIPS and we get inflation… At our current debt level paired with 1983 interest rates our debt servicing cost would be $2.4 trillion dollars (each year!)… The motivation to manipulate CPI would increase dramatically, leaving the government with two options; shamelessly manipulate CPI or default. This of course assumes that the options of cutting spending, and increasing taxes are off the table as we discussed in my previous blog.

If they use mostly TIPS and we get deflation… the American people (but mostly the conspiracy hacks) will question whether the government knew all along that a deflationary depression was coming. After all, borrowing using Tips is the equivalent of making a bet on deflation! This is a moral hazard - similar to a CEO shorting his own company’s stock.

If they use mostly regular bills and bonds… lack of market demand for the bonds will cause the fed to have to monetize more debt directly (by creating thier own demand [buying the treasuries themselves]), this WILL spark inflation and ultimately interest rates will rise to defend our currency. Those who refinanced last year will be winners. Those still in adjustable mortgages, and those with credit card debt, will be big losers.

My outlook? The deflationary jerk that markets experienced at the end of 2008 gave the US government a wide-open window of opportunity to sell treasuries by the truckload, as investors liquidated dollar denominated assets and took payment in cash (treasuries). I think it was a mistake for the fed not to sell even more, because a second market collapse probably won’t yield quite the same results. I think TIPS will make up a significant portion of future treasury demand, but hopefully not all of it.

A scary turn of events (which I hereby predict) will be if even TIPS don’t entice enough foreign borrowers, and these borrowers carefully unload their long maturity US debt and replace them with shorter maturity bills and notes. This will put the government at the mercy of market interest rates, especially if the dollar is pressured into sharing its reserve status with other currencies (in the form of IMF special drawing rights). I do however think that TIPS will find strong domestic demand from our new glut of savers, and over the next few years, I think the perceived conflict of interest at the Bureau of Labor Statistics in determining CPI will put further strain on the already tarnished relationship Americans have with their government.

Bottom line is this. I believe it’s best to position your own personal finances in a way that aligns your interests with those of your government (Corporate governance was so 2001, we need to start thinking about sovereign governance). Right now inflation and/or rapid growth is in the interests of our debt-laden government, and I’m skeptical about rapid growth.

The one thing that makes me nervous about predicting inflation is that it seems to be so universally expected by non-industry professionals. As the saying goes: “when the shoeshine boy is giving out stock tips, it’s time to sell your stocks.” Long-term, inflation of fiat currency has always been inevitable, but there is some short-term calamity that I’m missing. Something has to happen to ensure that the majority of investors get this wrong… The shoeshine boy NEVER gets it right.

I’ll be watching our government’s issuance of TIPS for clues.