Yesterday’s post got me thinking about inflation. As I said yesterday, “For me, the real risk of bonds is not providing adequate returns to keep up with inflation and taxes over long periods of time, a risk that is rarely talked about.”
Inflation is direct reduction to your investment returns whether you investing through a 401K, IRA, or taxable account. Lets look at an example. Today, the 10 yr US Treasury bond closed at a price which yielded 2.46%. That’s the nominal rate, the rate before inflation. Real rates represent how much you investment grows after the effects of inflation, or the real increase in your purchasing power. So, what is inflation today?
Ah, that’s not as easy to answer as it seems. First, what is inflation? The classic definition is that it is a general rise in the price level. This does not mean that if the price of oil or milk goes up its due to inflation. There are real supply demand issues that affect real prices in the economy. But inflation is a general rise of all prices, in theory. Its effects on the economy are not simultaneous and this presents the next problem, how to measure it. (For a discussion from the economist’s point of view see here. Also, just in case you don’t think the effects of inflation matter, here is an inflation calculator you can play with. Lets say in 1970 you spent $20. Today you would need to spend 5 time as much, over $100, to buy the equivalent goods)
OK. Which measure of inflation do you use? There are a bunch of them. Lets start with the most popular. Every month the gov’t, the BLS to be more precise, publishes the consumer price index, the CPI. And this measure comes in many flavors but the two big ones are the overall CPI and the core CPI, which strips out food and energy (because they’re volatile). The BLS has a great web site with all the CPI data you could ever want. I especially recommend their ‘Common Misconceptions on the CPI’. This addresses many of the questions, or accusations would be more accurate, made at the BLS and the CPI. Well worth reading. A newer measure which I really like is called the mean trimmed CPI and is published by the Cleveland Fed. It attempts to get even more accurate.
While the aforementioned measures get all the press attention I prefer to let the investment markets tell me what the inflation expectations are. From the fixed income markets you can derive what the implied inflation expectations are. For example, you take the 10yr UST yield and subtract from it the 10 yr US TIPS yield and you get what the market thinks the inflation rate is. There are also things like 5 yr 5yr forwards that tell you what the expected inflation rate is after 5 yrs, 5 yrs out. Huh? Anyway, you just go to a website, like the Cleveland Fed, and get yourself something like this;
It says that the ten year expected inflation rate is about 2%. Now, we have our nice 10yr UST bond yielding 2.46%. First, since bond interest is taxed as ordinary income we need to pay federal taxes. In a 25% tax bracket that means our 2.46% becomes 1.84%. God forbid you live in a state with state income tax as well. Now, subtract the inflation rate. Yep, that’s right, its a negative 0.12%. You’re losing purchasing power. This is not an investment!
My main point here is that everyone needs to remember the impact of inflation (and taxes) on their investments. The impact is big. Personally, I keep a hurdle rate in mind that I want to beat inflation and taxes by. My number is a minimum of 5% real rate. I keep that in mind when I choose my investments and revise it if needed every so often.
Full Disclaimer - Nothing on this site should ever be considered advice, research or the invitation to buy or sell securities. These are my personal opinions only.