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U.S. Treasury Inflation Bonds

Written By Brian Hicks

Posted January 31, 2008

With an emergency 75 basis point rate cut last week and another 50 point rate cut yesterday, the Federal Reserve has spoken. And no, despite all of the tough talk otherwise, price stability is nowhere in the picture.

So much, in other words, for the Fed’s cumbersome dual mandate as the real threat of inflation now goes completely ignored.

How else can you possibly explain a 1.25 point rate cut in less than ten days while the price of nearly everything under the sun continues to scream higher?

In fact, inflation has become so bad lately that according to Labor Department data released earlier this month, prices made their biggest jump in 17 years in 2007, as they rose by a whopping 4.1 percent. That’s on top of a 2.5 percent increase in 2006.

But with the Fed now committed more than ever to propping up not only the economy but the markets, inflation is now likely just only warming up.

That’s why for the conservative investor looking for U.S. treasury inflation bonds, I-Bonds have become another way to defend themselves against the ravages of rising prices with no risk to their principal.

Back to 70’s style Stagflation?

That’s true whether we’re headed for just the routine variety of rising prices or something much harder to deal with like recession or stagflation, that 70’s style affliction that gave birth to the misery index.

Stagflation, of course, is the worst case scenario. It is a period characterized by high inflation, high unemployment and slow growth. In short, it’s where the economy nose dives and inflation still soars. In the 70’s inflation went as high as 14%.

At present, however, the Fed seems to dismiss this scenario since it runs counter to the Keynesian notion that slower growth inevitably leads to lower inflation. According to the Bernanke playbook, in other words, rising prices will simply all go away as demand withers.

Of course, it sounds like a great plan if only it would work out that way, but that’s not necessarily likely because it ignores another reality.

Here’s why: A growing economy doesn’t explain every instance of inflation. It never has.

Just look at the 90’s. It was a period of enormous growth yet there was very little inflation. Using the Keynesian model inflation should have soared but it didn’t.

And look also at the 70’s- the last time our economy tangled with stagflation. The period was marked by soaring unemployment, little or no growth and rampant inflation.

In the Keynesian world, neither outcome should have happened, yet they both did.

The truth is, when it comes to inflation, it is the monetarists that have it right. Inflation is not about demand as much as it is about supply.

When the supply of money is larger than the demand for money inflation is the natural result. Inflation is, in other words, a monetary phenomenon caused by the expansion of the money supply itself.

And it’s far from over, even now, because nobody will ever confuse Ben Bernanke with Paul Volcker given the way the Fed has slashed rates over the past two weeks.

Treasury Inflation Bonds Defeat Stagflation

That’s where inflation bonds come in, because as the Fed continues to cut rates and prices go higher, the yields of these bonds increase right along with the inflation rate.

Additionally, as a U.S. Savings bond, the principal is 100% protected.

The interest that I-Bonds pay comes in two parts: a fixed interest rate and a variable interest rate. The fixed-rate portion is set when you buy the bond. Remaining interest payments come from the variable-rate portion, which changes twice a year based on inflation, as measured by the Consumer Price Index (CPI).

The most recent I-Bond is paying a 1.20% annual fixed interest rate and a 3.06% annualized variable interest rate. That means the composite rate is 4.28%.

And unlike the Treasury Inflation-Protected Securities (TIPS) that I wrote about earlier, you don’t have to pay taxes on the interest as it accrues, but when you redeem them or they mature. Moreover, they are only subject to federal taxes, not state or local taxes. And even then they may be exempt from even the Federal taxes if you use the bonds to pay for higher-education expenses.

Additional Treasury I-Bond facts:

· I-Bonds earn interest from the first day of their issue month.

· You can redeem them at any time after a twelve-month minimum holding period

· They are an accrual-type security

· They increase in value monthly and the interest is paid when you redeem the bond

· I Bonds are sold at face value; i.e., you pay $50 for a $50 I Bond

· I Bonds grow in value with inflation-indexed earnings for up to 30 years

· If you redeem I Bonds before they’re five years old, you’ll forfeit the three most recent months’ interest.

· As of January 1, 2008, the annual limitation on purchases of United States Savings Bonds is set at $5000 per social security number. That’s reduction from the previous $30,000 limit.

So break out the bell bottoms, the black lights, and the Jiffy Pop. Climb into the magic bus and crank up the Doors. Helicopter Ben is driving.

He says we’re just detouring the 30’s but I don’t believe him. The truth is he’s got the wrong map.

This bus may just be headed back to the 70’s.

Protect your principal and hedge your portfolio against that ride with an investment in I-Bonds.

To find out how to buy I-Bonds click here.

Wishing you happiness, health and wealth,

Steve Christ, Editor

Wealth Daily