Treasury Inflation Protected Securities (TIPS) Investing

Written By Geoffrey Pike

Posted April 4, 2014

If you don’t trust the government with your money, you need to read this…

Right now, there’s a decent amount of debate over the accuracy of the Consumer Price Index (CPI) — what we use to measure the change in the price level of a basket of goods and services that are commonly purchased. The controversy is over the calculation methods and overall accuracy of the number.

You see, it’s actually a somewhat subjective number because no household is purchasing the exact same products in the exact same quantities. And the truth is there tends to be more distrust over the CPI numbers amongst those who already distrust government in general.

Most people who distrust the CPI think it understates consumer price inflation. And obviously, the government would certainly have several reasons to want to understate the number…

First, there are cost-of-living adjustments that the federal government has to make for certain things. The big one is Social Security. The higher the cost-of-living increase is, the more the government has to pay out.

Second, the government would rather have the public perceive inflation as lower than it actually is. If folks thought consumer prices were rising faster than what’s currently stated, more voters would be upset at the government. They would more easily realize their wages are not keeping up with their cost of living.

Third, an understated CPI can also benefit the bond market by keeping interest rates lower. If inflation is perceived to be lower than it actually is, interest rates will also be lower, allowing the government to borrow more money at cheaper rates.

There are other motivations for politicians to understate the CPI, but those are just a few of the big ones.

Hedonic Quality Adjustments

When calculating the CPI, there’s a process called hedonic quality adjustments.

There are sometimes changes in the goods and services used to measure the CPI. Some are no longer in high demand, and they get replaced in the index. The CPI calculation is supposed to account for changes in the quality of the products.

Again, this whole process is highly subjective.

For one thing, the quality of a product can be highly subjective. At the same time, there may be some justification in accounting for quality in certain circumstances.

If a shirt is made out of a better material, for example, it would probably be reasonable to make a price adjustment to take this into account.

But there are other things that are hard to measure. What about an iPad? They didn’t exist 10 years ago, and the quality gets better (at least in most people’s view) for each new release.

Should a computer that is twice as fast as a computer from two years ago have a major price adjustment? If that’s the case, then the cost of computers and other electronics are falling much faster than we can imagine.

What about televisions? You can buy a bigger television with a better quality picture at a cheaper price than you could just a few years ago.

Of course, this has nothing to do with monetary inflation. The price of electronics has gone down in spite of monetary inflation due instead to productivity and the almost exponential growth in technology.

It’s actually quite amazing when you think of what prices would look like if there were no monetary inflation in our world.

Computers and televisions would be falling in price even faster than they are now. Most things would get cheaper as technology and productivity levels increased.

So while these quality adjustments may be good for measuring the rate of consumer price inflation while accounting for quality, they don’t tell us how much damage is being done by monetary inflation.

You can have little or no consumer price inflation while still having monetary inflation. But the monetary inflation is still doing damage by redistributing and misallocating resources.

Should We Use the CPI?

While I don’t completely trust the CPI, I think it can still be useful.

There’s a calculation that is used. While it can and does change in the products being used, it’s not as if someone is just pulling random numbers out of thin air. It does provide some degree of accuracy in terms of what consumer prices are doing.

So while I think the CPI may be understated, I think we can still find it useful in determining trends. It can at least tell us if price inflation is picking up, slowing down, or staying about the same. When you look at the CPI, you should use it in context of what it has been over the last few years.

Incidentally, while I think the CPI may be understated as compared to actual consumer price inflation, I don’t think it is wildly off, either.

There are some people who claim prices are rising at 10% or more right now, but I don’t pay much attention to this. I can see prices with my own eyes at the grocery store and other places — they are going up slowly in most cases, but not usually more than 10% annually. (In this, I do not include health insurance premiums, which are rising for reasons other than just inflation.)

One other important thing to note is that higher prices are not spread out evenly. You can have higher asset price inflation that isn’t being measured in consumer prices, which we see happening now. The monetary inflation we have seen over the last five years has not led to really high consumer price inflation, but we have seen stocks soar.

Investing for Inflation

While it is difficult to measure how fast prices are rising, we can be certain that they are and that there will likely be more to come. We still have to protect our money from the threat of inflation to avoid losing purchasing power.

Some investment advisors will recommend buying Treasury Inflation Protected Securities, or TIPS. These are essentially government bonds that will rise in value based on inflation as measured by the CPI.

I don’t recommend that anyone invest in TIPS. As discussed above, if the CPI is understated, your bonds really won’t be keeping up with the actual inflation rate.

In addition, if you are going to buy a hedge against inflation, it should be something that goes up above and beyond the rate of inflation, such as gold or silver.

If you have 25% of your investments in TIPS and we have a period of high consumer price inflation, your TIPS aren’t going to help along the rest of your portfolio at all. They will just keep up with inflation (if that) for that 25% that you invested.

If you have 25% in gold and we have really high inflation, however, gold will likely go up even more and help along the other parts of your portfolio that may be struggling to keep up with inflation.

Another important thing to consider is your retirement. If you have a fixed pension, you are obviously vulnerable to inflation.

One strategy you can implement is to buy residential real estate for investment purposes. You can get a fixed-rate mortgage so that your fixed pension payment will cover the cost of your mortgage and other expenses. Your income will come from the rent.

The good thing about this strategy is that your fixed pension will continue to cover your fixed-rate mortgage regardless of inflation. But if there is significant inflation, you will probably be able to raise the rent you charge over time.

You can also implement this strategy with Social Security checks. If the government is cheating you on the cost-of-living increases, then it won’t matter as much because you will be using it to pay your fixed-rate mortgage (or mortgages). Any cost-of-living adjustment would be additional money, even if it were understated.

While we can’t change the way the government reports the CPI, we can still find use in the calculation. We can also take steps to protect ourselves from a loss in purchasing power over time.

Until next time,

Geoffrey Pike for Wealth Daily

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