There are reasons TIPS and Inflation are not a perfect match to protect your portfolio from rising prices and costs. The first reason should be fairly easy for the average person to see. Ask any person on the street today how much the price of a gallon of gas has increased today and they tell you, “A lot.” Ask Chairman Bernanke how much inflationary pressures he sees in his rate forecast and he has repeatedly said, “Not much.” Who is right? The answer to that question will have a lot to do with where you decide to put your cheap dab recyclers money in the coming months and years.
TIPS and Inflation have been long associates, and for many years there was good reason for this link. TIPS (or treasury inflation protected securities) were designed to give bond investors something they always desired – an investment in a yield producing asset whose income (and hence purchasing power) would be indexed to the rate at which prices (in aggregate) were rising. Essentially this was a good design – an investment people could put their money in and have some assurance that the income they received in retirement from those assets would retain the purchasing power needed to maintain their lifestyle.
For a number of years people were reasonably happy with their ability to purchase securities linked to the CPI (an inflationary gauge). As time wore on however people began to find that the costs of certain necessities (healthcare and medication most notably) were sky-rocketing while their bong yields weren’t keeping up. Even so, people had good reason to believe it would all even out eventually because if the costs of one thing were going up, something else must be going down or be more valuable relative to its cost. This is what the aggregate price index is supposed to measure after all.
Eventually things went very wrong for indexed treasury holders, as the CPI was re-written multiple times beginning with the Carter administration with more and more aggressive changes with each subsequent Presidency. The reason for all the changes is the same: spiraling costs of benefit entitlements have forced the government to find or manufacture ways to reduce the future costs of programs. The way to do this way to alter the CPI computation.
While it is beyond the scope of this article to describe those changes in detail, suffice to say that the concept of substituted (lower cost) goods is aggressively used. What this means is that as prices in a popular good rise, the CPI substitutes (lower cost) items that are almost as good or essentially performing the same as the popular high-priced good. What this means for you and I as treasury inflation protected securities owners is that our purchasing power is guaranteed to buy “almost as good” items rather than the goods and services we had originally planned to buy with our retirement income. This is not the intention most investors had in mind when they initially invested in TIPS.