TIPS, can you trust them?

[zaplunken]

This is NOT a political thread so let's not go there. I do not want this locked, I am serious in what I am asking. It does address the government and it's credibility. If this has been discussed, I suspect it has, please provide a link if you can.

I have wanted to better allocate my fixed income and the Vg TIPS fund is one I wanted to add. The thing that worries me is many things are tied to inflation like SS COLAs, probably COLAs for government pensions, TIPS, IBonds and probably many more. Since the government has a vested interest in understating inflation ( no SS COLA for 2010) isn't it reasonable to question just how badly the calculation of inflation is being cooked? Maybe if you trust the government this is not a worry to you but I wouldn't trust them any farther than I can throw a freight train. So I wonder if putting money into the TIPS fund isn't playing cards with a marked deck?

Thoughts? Anyone feel that inflation is not now or will not in the future be reported honestly thereby seeing TIPS as a poor investment choice? I don't have anything to substitute for TIPS, I don't think there is anything (IBonds would suffer the same fate in my thinking).

[TheDan666]

I can't, and don't think anyone, can TRULY answer that question. There is some logic to your proposition. However, have you considered the opposite side of your statement? You could make the case that because of the vast amount of foreign debt the US has, they actually have an interest in INCREASING inflation so as to make the interest on the debt less onerous. That's all I got.

--The Dan

[MWCA]

You are questioning the credibility of the United States Government. Which many of the folks here posting have bled for or served this institution.

So your little this is not a political thread statement does not change the fact. That in all likely hood it is a political thread.

Just my thoughts like you asked for.

[oneleaf]

Since the government has a vested interest in understating inflation ( no SS COLA for 2010) isn't it reasonable to question just how badly the calculation of inflation is being cooked?

Are you saying there was inflation over the past year?

[pkcrafter]

As you have described your concerns, it is political. It won't fly. I suggest you post the question on M* forums.

Paul

[nisiprius]

Well, if you don't trust Treasury securities, don't buy them. However...

1) The government isn't a monolith. The CPI is calculated by the Bureau of Labor Statistics. The parts of the government that are affected by CPI calculations would be the Social Security administration and the Treasury. Different bureaucracies within the government tend to be fiercely independent of their turf. The BLS is part of the Department of Labor. It's not obvious why the BLS would want to carry water for those other agencies.

2) The calculation of the CPI is transparent. It doesn't emerge from a secret black box. On the BLS website you can find out more than you'd ever want to know about the composition of the market basket, how owner-equivalent rent is computed, and what past CPI figures would have been if calculated according to current methods. The CPI could be openly fudged--for example, the President could order the BLS to freeze the CPI at some fixed number, I suppose--but fudging couldn't be concealed.

3) Groups with the direct interest in the CPI, such as AARP, are not complaining about the CPI. I directly queried AARP on this, in an email they indicated that they believe the CPI calculation is accurate; their only quarrel with it is that CPI-W doesn't reflect the expenses of the elderly well. They want Social Security indexed to a market basket that more closely reflects the expenditures of Social Security recipients. The BLS is currently calculating such an index experimentally under the name CPI-E. It's not hugely different from CPI-W.

4) The CPI has been calculated by the Bureau of Labor Statistics since 1919. During that time there have been some periods of high inflation, notably during the Nixon era, and as far as I know nobody has suggested that the CPI was fudged during those periods. For example, the CPI continued to rise during the Nixon price freeze, showing that the price freeze was ineffective, which was presumably embarrassing to "the government."

5) Some sources that have complained about the CPI being fudged maintained that the use of owner-equivalent rent was deceptive, and that the CPI should be calculated on the basis of home prices, not owner-equivalent rent. If you accept this, then the CPI is currently significantly overestimating inflation.

6) Treasury securities are a popular investment of people of all shades of the political spectrum who want to minimize risk. As of 2007, for example, two notable conservatives were reported to be have large investments in Treasuries. One of them in particular had "$2.5 to 11 million" of his "$21.4 million to $100 million" invested in the Vanguard TIPS fund.

The most plausible scenario I've heard for a fudged CPI would be if the government instituted price controls, and the result was for consumers to buy a significant amount of their real "market baskets" on the black market, and the Bureau of Labor Statistics shoppers did not follow suit. Actually I wonder what the shoppers do if they literally cannot find the items they are supposed to be pricing.

[zaplunken]

Since the government has a vested interest in understating inflation ( no SS COLA for 2010) isn't it reasonable to question just how badly the calculation of inflation is being cooked?

Are you saying there was inflation over the past year?

Are you saying there wasn't? Maybe you don't pay attention to the prices of things you buy but I do and I don't see anything going down. Whether is it groceries or energy, it costs more. And that's the point really, whoever decides about inflation IMO has already lied about it for 2010. I'm sure if you asked seniors on SS they'd have a pretty firm opinion about no COLA for 2010!

Despite some people that are driving this to be locked, I want to try to stay away from being political so I'm ignoring their comments and addressing "do you feel that TIPS will be manipulated and therefore not a good choice despite there is no other inflation protection vehicles"?

I want to allocate about 1/3 of my fixed income to TIPS but I wonder if this is foolish?

[zaplunken]

Thanks nisiprius that was a detailed post. I appreciate your effort and thoughts.

[oneleaf]

Are you saying there wasn't? Maybe you don't pay attention to the prices of things you buy but I do and I don't see anything going down. Whether is it groceries or energy, it costs more. And that's the point really, whoever decides about inflation IMO has already lied about it for 2010. I'm sure if you asked seniors on SS they'd have a pretty firm opinion about no COLA for 2010!

But SS recipients got a 5.8% increase in 2009 even though prices already started falling through the last quarter of 2008, as the financial crisis deepened. COLA adjustments are calculated 3rd quarter to 3rd quarter. Prices decreased by the time the 2009 COLA adjustments (a substantial 5.8%) were in effect.

I certainly do pay attention to prices because I do all my parents budgeting and financial management and they are in retirement and collecting SS, and I deal with their expenses.

What I've noticed is that those that complain about cooked CPI's just "notice" it. The BLS, on the other hand, "calculates" it. I have to go with the BLS on this one.

[Karamatsu]

I think it's quite possible that policy objectives could shade the computation of the CPI by shading the inputs in some way. Certainly the government here has been known to publish false statistics in order to create the desired impression. But given all the people watching the CPI very, very closely, I doubt that the shading could affect an individual investor by much. From the government's point of view, even a quarter of one basis point is a significant saving, but for most individuals it's down in the noise, and nowhere near as significant as regional differences in price levels, or the difference between their individual spending and what the CPI considers typical. I think it's an intrinsically flawed measure that is nevertheless the best option we have at the moment for a general figure applicable to everyone wherever they live.

[oneleaf]

as far as what I've noticed:
- groceries: slight increase
- dining: slight decrease (contrast to above)
- gas - down big time
- heating bill - down big time
- clothes - down (due to sales)
- traveling, hotels, plane tickets, car rentals - down big time.
- everything else - no big change noticed

this is 3rd quarter to 3rd quarter (what SS COLA is based on)

I don't think there is anything to complain about regarding no COLA change in 2010.

[tetractys]

Yes, thanks Nisiprius! your answers to this question seem to come from more angles every time.

Questioning the CPI-U comes up regularly on this forum, which I believe is congruent with at least one reason the CPI-U is accurate for what it was designed to do. That is it's transparency and input from many varied public sources. Sorry I'm not an expert on it's exact design; but the Bureau of Labor Statistics is, so refer to them for the design specifics. The links in the Boglehead's Wiki.

Questioning things in a basic and logical way is apolitical, and after all, it's one of the things that make Bogleheads tick

Best regards, Tet

[tfb]

Not a problem. If the market believes the CPI does not reflect true inflation, the participants will adjust the real rate to compensate for it.

[musbane]

I agree that the calculations are transparant. Therefore if they are currently off a bit to one side or the other - for whatever reason - the current price of TIPS reflects this.
The concern would be that the government could - I don't say would - change things sometime in the future. If they did, the new innacuracy would be reflected in new TIPS prices but existing holders would be seriously affected as their bonds adjust to their new values.

[metalman]

The OP says "Maybe if you trust the government this is not a worry to you but I wouldn't trust them any farther than I can throw a freight train."

I'm really very glad he didn't make a political post.

Could be there is every incentive to tilt the CPI measure. If you don't like how it's done, take that into account in your investments. If you really don't "trust" the government at all, maybe you should just buy gold and guns.

[neverknow]

Maybe you don't pay attention to the prices of things you buy but I do and I don't see anything going down. Whether is it groceries or energy, it costs more.
...
and therefore not a good choice despite there is no other inflation protection vehicles"?

Those of us who have living memory of the inflation of the 70's - it's like a hot button, this subject overly concerns us.

I quoted you, but clipped to what I wanted to address.

My households food and utility bills are down in 2009, from 2008. We keep yearly figures, so I know this is a fact. Sure, I've noticed the reduced package sizes, in the grocery store -- but for yearly figures, they are less then 2008.

It is Health Care inflation (or education cost inflation) that assaults all of us. Both of these things are such a small percentage in the official CPI -- that if we are paying more then the average -- it can appear to us that inflation is rampant.

I haven't done so for Health Care - I have done so for Energy, but one strategy to pace the expenses you actually experience is to invest in that sector. Vanguard has sector funds for both Health Care and Energy. I also invested in the etf XLU (utilities sector). I also bought stock in my Trash company - enough so that it's dividend pays my trash pickup bill.

Discussing / wondering about official CPI ends up being futile - or that was my conclusion after thinking about it for many months. It is what it is. An inflation policy is pursued as something "good" by our central bankers which perpetually devalues our money -- and there is nothing we can do about that. I can then get pretty agitated that interest I earn at my local bank (which generally pays the rate of inflation) then gets taxed as income, when it is not income at all - it is merely my stored savings trying to keep up. But there again, is something that is not something I can do anything about. Short Term Treasuries usually also pay the rate of inflation, because investors demand that --- apparently twice in the past decade, they are not demanding that. Sometimes I wonder why we don't just take our money home with us, if they are not even going to pay the rate of inflation -- but stores of paper bills are a fire hazard, etc.

Good luck, working out what is the right solution for you and your family.

I love I Bonds. However, I am only a reluctant buyer of a TIPs mutual fund. I would rather construct a CD Ladder.

For whatever that is worth.
neverknow

[MarcMyWord]

Not a problem. If the market believes the CPI does not reflect true inflation, the participants will adjust the real rate to compensate for it.

tfb, I've read your many posts here, and your own articulate and thoughtful web site, and I'm not equipped to debate the fine points of bond market pricing. But I've always found it very difficult to believe that if the government diddles with the CPI's relationship to "inflation," doubts about the validity of CPI will simply show up directly and automatically in TIPS yields. (You are, of course, far from alone in making that point.) It seems much more likely to me––on a gut level, not anything related to an "all information is reflected in prices" argument––that when the aroma of inflation is in the air, investors large and small cast aside doubts about CPI and stampede toward TIPS, because TIPS are essentially "the only game in town" for inflation–linked U.S. bonds. For this reason, I also have difficulty believing that the vigilance of AARP, or the "transparency" of the CPI calculation ("transparency" does not assure accuracy), or other factors cited in this thread and others like it necessarily guarantee the accuracy of CPI or its internal weightings. (When food prices rise continually, and medical costs grow by leaps and bounds, I really don't care if the prices of cell phones and flat screen TVs are falling.)

The concern would be that the government could - I don't say would - change things sometime in the future. If they did, the new inaccuracy would be reflected in new TIPS prices but existing holders would be seriously affected as their bonds adjust to their new values.

Unless terms have changed since the TIPS program began, there have always been some rather large escape clauses for the issuer, i.e., the federal government:

"Any revisions the Bureau of Labor Statistics (or successor agency) makes to any CPI-U number that has been previously released will not be used in calculations of the value of outstanding Treasury inflation-protection securities." This absence of retroactivity can work to the benefit or the detriment of existing TIPS holders, depending on the "direction" of the revision.

And: "If the CPI-U is rebased to a different year, Treasury will continue to use the CPI-U series based on the base reference period in effect when the security was first issued as long as that series continues to be published." Same comment as above.

And the possible largest of all: "If the CPI-U is discontinued during the period the inflation-protection security is outstanding, the Treasury will, in consultation with the Bureau of Labor Statistics (or successor agency), determine an appropriate substitute index and methodology for linking the discontinued series with the new price index series. Determinations of the Secretary of the Treasury in this regard are final."

Source: http://www.treasurydirect.gov/news/pres ... mnewmk.htm

Yes, I do believe in including TIPS exposure among our investments. But no, I'm not truly calm about it. A person doesn't have to be "suspicious" of the government in order to simply wish that there was a more truly "arms length" relationship between the entity which issues the TIPS and the entity which defines "inflation."

Marc

[sscritic]

And: "If the CPI-U is rebased to a different year, Treasury will continue to use the CPI-U series based on the base reference period in effect when the security was first issued as long as that series continues to be published."

The BLS currently maintains two series using two base years

U.S. All items, 1982-84=100 - CUUR0000SA0
U.S. All Items, 1967=100 - CUUR0000AA0

The caveat you quoted says that if a 40 year TIPS had been issued in 1970, they would still be using the base year of 1967. I think that is appropriate, so that no switching in favor or against bond holders would have occurred in 1984 when the new base years were adopted. If you are concerned about the series being dropped during the life of the bond, the fact that they are maintaining the 1967 series 25 years after the adoption of the 1982-1984 series should allay your fears. Unless you have some information that they are going to stop publication of the 1967 series after 50 years in 2017 and the 1982-84 series (the basis for current TIPS) shortly thereafter (- maybe they will abolish the CPI!!!), I wouldn't worry about the CPI-U disappearing.

[zaplunken]

Thank you for all your comments. I feel I understand this better and that TIPS are not being manipulated to any great extent.

I'm pleased we were able to avoid getting into polly ticks and having this thread locked. There is such great insight at the Bogleheads forums! I am/(we are) fortunate to have such a wealth of knowledge at my (our) finger tips!

[RustyShackleford]

The OP says "Maybe if you trust the government this is not a worry to you but I wouldn't trust them any farther than I can throw a freight train."

I'm really very glad he didn't make a political post.

Well, I think the point is, he didn't make any "red" versus "blue"
judgement here, and I don't get the impression that he mistrusts the
government more in the last year than he did before that.

For the record, I am a fan of the current administration and did not
feel his question was inappropriate.

[zaplunken]

Well, I think the point is, he didn't make any "red" versus "blue"
judgement here, and I don't get the impression that he mistrusts the
government more in the last year than he did before that.

You are correct! BTW, she didn't make any red vs blue judgment.

The word government does not define a specific party. Too bad MWCA completely missed the point - the government in this case does not mean the country, it's patriots or it's historic past, I just ignored a misguided comment for fear of turning this into a red blue argument.

[fishnskiguy]

Adding to Nisiprius' excellent post, let me point out that I retired from the Navy in 1993 on a CPI adjusted pension.

We live the same lifestyle now as the day I retired. No better, no worse. Dine out about as often, replace our cars about as often, travel about as often. My pay has increased 154% since 1993, and we are holding our own. No complaints at all.

Remember, those faceless bureaucrats at BLS have a vested interest in calculating the CPI as carefully as possible since their pay and retirement benefit is a direct function of their work. And if any of them thought some supervisor was leaning on them to cook the books, they would run to an investigative reporter for the Washington Post or New York Times so fast it would make your head spin.

Chris

[RustyShackleford]

You are correct! BTW, she didn't make any red vs blue judgment.

We're being a little thin-skinned here, aren't we ? I'd be happy to
use gender-appropriate pronouns if you'd get a moniker than gives
any hint about your gender (caveat: maybe it did, if my German was
better).

[Beagler]

Words from Mr. Bogle


Government: Making the Numbers Fit

Many of the numbers we cannot count on, paradoxically, are produced by our Federal Government....we're being grossly misled by government data, including the vital numbers that have become central to our national dialogue, such as our ...(GDP), our unemployment rate and our inflation rate....
The underestimates in the Consumer Price Index (CPI) are even more egregious." (pages 100-101, Enough)

[Prokofiev]

You are correct! BTW, she didn't make any red vs blue judgment.

I'd be happy to use gender-appropriate pronouns if you'd get a moniker than gives any hint about your gender . . .

Notice the blue lipstick?

[RustyShackleford]

You are correct! BTW, she didn't make any red vs blue judgment.

I'd be happy to use gender-appropriate pronouns if you'd get a moniker than gives any hint about your gender . . .

Notice the blue lipstick?

VERY cool image, Ms Zaplunken. It just looked like some bizarro
abstract thing to me, until "lipstick" was mentioned ...

[CaptMidnight]

Since I regard deflation as a likelier outcome for the next few years than inflation, I am not overly concerned about distortions in the calculations by the BLS. That said, if I remember correctly, the replacement of houses in the CPI with "owner's equivalent rent," which occurred about 1982, seems to me to have been a deliberate attempt to understate inflation. That was at the tail of the first '70s housing bubble and, of course, the big inflation period.

[imagardener]

...
It is Health Care inflation (or education cost inflation) that assaults all of us. Both of these things are such a small percentage in the official CPI -- that if we are paying more then the average -- it can appear to us that inflation is rampant.
neverknow

This is why inflation is such a personal matter, it affects everyone differently.
Our health insurance costs just went up 22% for 2010 and last year went up 25%.
That is our #1 expense in our household budget, around 20%.

Yes I think the way CPI is calculated is skewed and make no judgement as to whom it favors. It just doesn't favor us.

All I know is that we are holding our breath for each of us to make it to Medicare age so this expense will be somewhat lower because we will be joining the largest pool of insured people.

[nisiprius]

Just to be perfectly clear. Yes, I think it's nutty to suggest, as some sources really seem to be do, that inflation is secretly running 8% today and that the BLS is hiding it. (I'm reserving the word "nutty" for claims that it is 8% now--not to claims that events already in motion will inevitably lead to 8% inflation in the future).

On the other hand, sure, governments, just like other entities, break promises. And one could certainly imagine an inflation-related situation in which TIPS are a larger problem than nominal bonds and the government might selectively decide to break just the TIPS promise. But that's a storyline.

The thing is, I don't believe you can make investment decisions on the basis of storylines. Companies default on bonds all the time and you can get numbers on default rates for bonds rated AAA versus bonds rated B. You can't get numbers on how frequently a baseball team will lose the World Series because a first basemen lets an easy grounder roll between his legs, or how often an entire city will burn because a cow kicks over a lantern, or how frequently a president will declare a bank holiday. Events like these are not all that rare. But even after the fact they unfold as unique chains of events that would have been impossible to foresee--and are sometimes hard to believe even after they occur.

For planning purposes, in deciding how to deploy investments, you just have to shrug your shoulders and assume life insurance will pay the death benefit, that you can withdraw money from the credit union whenever you want, and that Vermont will remain part of the United States of America.

It's reasonable and prudent to understand some of the possible catastrophes and whether there's any safety net in place, but not to take important financial actions based on long chains of "what ifs." "The kingdom was lost all for the want of a horseshoe nail," but that doesn't mean you should invest in horseshoe nail futures. What if the bank folds and what if the FDIC is out of dough and what if so many members of Congress are out sick with H7N11 Musteline Flu that they can't muster a quorum to authorize the FDIC to borrow more... Sure, it could happen, but don't put $50,000 in cash in your freezer compartment on the strength of it.

So, for planning purposes, I takes TIPS "at face value." My personal belief? 8% annual inflation, TIPS will be OK. 8% daily inflation, TIPS will be toast, but you can't get there except by way of a storyline. Plan on some of your junk bonds defaulting, plan on TIPS behaving as specified.

[richard]

Healthcare was 15.5% of GDP in 2006 and is a larger percentage today. Medical care is about 7% of CPI-U. Can anyone explain the difference?

[sscritic]

Healthcare was 15.5% of GDP in 2006 and is a larger percentage today. Medical care is about 7% of CPI-U. Can anyone explain the difference?

What about the percentages for defense? Is defense the same percentage of CPI-U that defense is of GDP? How much did you spend on defense last year? How much higher was it than five years ago?

My guess is the answer is that you don't buy the GDP, you buy goods and services.

Taxes not directly associated with specific purchases, such as income and Social Security taxes, are excluded, as are the government services paid for through those taxes.

[richard]

My guess is the answer is that you don't buy the GDP, you buy goods and services.

Taxes not directly associated with specific purchases, such as income and Social Security taxes, are excluded, as are the government services paid for through those taxes.

That sounds right

At least half of US healthcare spending is by the government.

[Lbill]

See this paper co-authored by Zvi Bodie:

A TIPS Scorecard: Are TIPS Accomplishing What They Were Supposed to Accomplish?Can They Be Improved?

Abstract:
In September 1997, the U.S. Treasury developed the TIPS market in order to achieve three important policy objectives: 1) to provide consumers with a class of assets that allows for hedging against real interest rate risk; 2) to provide holders of nominal contracts a means of hedging against inflation risk; and 3) to provide everyone with a reliable indicator of the term structure of expected inflation. This paper evaluates the achievement of these objectives and analyzes prospective ways to better meet these objectives in the future, by, for example, extending the maturity of TIPS and/or the use of inflation indexes catered to particular geographic regions or demographics. We conclude by arguing that while it is tempting to consider completing markets by introducing more TIPS-like securities indexed to inflation rates that are more tailored to particular demographics, our analysis suggests that TIPS indexed to CPI do in fact facilitate good synthetic hedges against unexpected changes in inflation for many different investors, since the various inflation measure are very highly correlated. We do however argue for extending the maturity of TIPS.

[gd]

Seems to be relevant here, at least a glancing blow. Mr. Ritholtz is not known for pulling his punches:

http://www.ritholtz.com/blog/2010/01/wh ... -contempt/

(snip)
For those of you who may be unaware, Boskin is the economist/weasel/fraud who helped to officially distort the CPI, making it more or less worthless as a measure of inflation. The Boskin Commission was an act of fraud, a backdoor method to suppress Social Security cost of living adjustments (COLAs). To be blunt, it was an act of cowardice. Rather than man up and say “fix this, its broken, we can’t afford it” the commission took a different route — they fabricated a series of nonsense adjustments that artificially lowered CPI by 1.1%.

[Beagler]

Didn't the CPI change the grade of meat at one point as well, downgrading the type of meat included?

[sscritic]

Didn't the CPI change the grade of meat at one point as well, downgrading the type of meat included?

No, that was your local supermarket. You used to be able to buy prime and choice. Now they sell select and standard under made up names that have no official standing with the USDA. “Farmers Favorite”, “5 Star”, “Ranchers Reserve”, “Blue Ribbon” or “Butchers Pride” anyone?

[Chet]

However, have you considered the opposite side of your statement? You could make the case that because of the vast amount of foreign debt the US has, they actually have an interest in INCREASING inflation so as to make the interest on the debt less onerous.

I believe the OP was not concerned about actual inflation being too low, but was concerned about it being under-reported.

[Chet]

Not a problem. If the market believes the CPI does not reflect true inflation, the participants will adjust the real rate to compensate for it.

Then why do we need TIPS at all? By the same token, buyers of ordinary Treasuries can adjust the interest rate to compensate for actual inflation.

TIPS are promoted as protecting against unexpected inflation, and depend on the govt CPI to match actual inflation.

[MarcMyWord]

Didn't the CPI change the grade of meat at one point as well, downgrading the type of meat included?

http://www.bls.gov/cpi/cpiqa.htm#Question_3

Marc

[Chet]

Didn't the CPI change the grade of meat at one point as well, downgrading the type of meat included?

http://www.bls.gov/cpi/cpiqa.htm#Question_3

Marc

Look at the last sentence in the first paragraph:
the CPI's objective is to calculate the change in the amount consumers need to spend to maintain a constant level of satisfaction.

I had thought that the CPI tracked the actual changes in prices of a fixed, predefined basket of goods, which would be a true measure of the dollar's loss in purchasing power. Now (upon reading further) I see it tracks this nebulous "constant level of satisfaction", which attempts to model consumer behavior in reacting to changes in prices, and estimate consumer satisfaction levels.

If the BLS would just stick to tracking actual prices, they wouldn't need to have a whole web page defending their methods.

[richard]

I had thought that the CPI tracked the actual changes in prices of a fixed, predefined basket of goods, which would be a true measure of the dollar's loss in purchasing power. Now (upon reading further) I see it tracks this nebulous "constant level of satisfaction", which attempts to model consumer behavior in reacting to changes in prices, and estimate consumer satisfaction levels.

If the BLS would just stick to tracking actual prices, they wouldn't need to have a whole web page defending their methods.

How much did your computer cost in 1983? What does a 19" B&W TV cost today?