Treasury Inflation Protected Securities (TIPS) comes up repeatedly in conversation about inflation protection. In particular, many people claim they would be fine for future inflation in the U.S. and are the “perfect” inflation hedge according to some. Perfect? Really? Those sound like famous last words to me!
First, we’ll ignore that the “perfect” inflation hedge has recently auctioned 10 Year TIPS at a negative rate which will ensure loss in purchasing power.
Secondly TIPS, as has been discussed here before, have only been in the U.S. since 1997 and have never been through high inflation of the US dollar. So calling them a “perfect” hedge is a dangerous assumption considering they have not sustained any serious test (we’ve had disinflation/deflation since they were introduced and no serious inflation).
But I want to start talking more about business intuition and investing risk. This is because investing is not a hard science. Investing is a social science because we are dealing with human behavior at the individual level which amplifies into the millions of decisions the markets make each day about the price of things. I also want to talk about business intuition because I often see so many very dangerous investment assumptions being made using mathematical models with some pretty flimsy evidence. Just because you can express something in a formula does not mean it is correct.
Just because you can express something in a formula does not mean it is correct.
In particular about TIPS, let’s completely ignore the models of numbers showing how they move in a chart. Sure they may be useful for some things, but underlying TIPS are people and people can’t be modeled. In investing I find that understanding history is often just as important as any academic model you may encounter. So, let’s look just at the recent history of bad inflation in the US as a way to assess the extra spreadsheet risks that can affect investors. Extra spreadsheet risks are what I call the risks that a spreadsheet model will never show you. They are probably more colorfully called Black Swans. This is where some business intuition comes into play.
Looking at history, my intuition warns that TIPS would never function anything like a perfect inflation hedge. This is because TIPS are directly linked to the policy decisions that are normally the cause of high inflation. And these policy decisions behind inflation are almost always political in nature. So TIPS, through this process, are really tied to politics and all the nasty crud that entails.
Let’s review recent history of the 1970s to provide a possible framework on how TIPS could get pulled into a problem. Here is a short review:
1) President Nixon closes the gold window in 1971 defaulting on US obligations to foreign holders of dollars to exchange the currency for gold. This layers on the decision in 1933 by Franklin Roosevelt to confiscate the gold of Americans defaulting on that promise as well.
2) Nixon then implements price and wage controls in a futile effort to control inflation. At the same time, behind the scenes, there is some evidence he was putting pressure on then Fed Chairman Arthur Burns to keep a loose monetary policy to help him with his re-election bid.
Richard Nixon demanded and Arthur Burns supplied an expansionary monetary policy and a growing economy in the run-up to the 1972 election. – How Richard Nixon Pressured Arthur Burns – Burton A. Abrams
3) President Ford comes into office and decides to tackle the problem of high inflation not with addressing the actual problem of restricting the money supply, but with his Whip Inflation Now (WIN) program. It was complete with buttons and a bizarre plan for people to help stop inflation themselves by submitting in their comments to the governement about it. The plan was called “unbelievable stupidity” by then economic advisor Alan Greenspan when he first heard about it (as recounted in his book The Age of Turbulence).
4) President Carter came in and gave speeches, had commissions and other ineffective mechanisms while inflation hit double digits. The one good thing he did was bring in Fed Chairman Paul Volcker who knew the problem of inflation was only going to be solved by turning off the money supply, and not speeches.
5) By the time President Reagan came around, Volcker had kicked off a deliberate recession to slow down the growth of money and finally stop inflation. At the time of this action, prime interest rates had risen to over 20%. It was the closest the US had come to true hyper-inflation since the Civil War or perhaps the Continental Congress.
The bottom line is that policymakers let savers and investors languish for over a decade in the 1970s with nearly 50% loss in purchasing power and no real returns for stock and bond holders. They didn’t care about people that held dollars. If they did care about inflation and the dollar they wouldn’t have waited so long to fix what was obviously wrong. In fact, as shown above, there is evidence that politicians like Richard Nixon were using monetary policy for their own gains. Of course, the same kind of political pressure likely happens under any presidency.
And I know some people (and even eminent economists) are thinking: “They didn’t know back then what was causing the problem so you can’t blame them!”
My answer is: Of course I can blame them. But this defense (which I’ve heard in more elaborate form from some well-regarded economists) falls flat for two reasons:
1) They knew perfectly well what was causing the problem and choose to not do anything about it. So they were acting maliciously and irresponsibly during this period.
- or -
2) They didn’t know what was causing inflation, despite mountains of historical precedent on the subject, and are therefore incompetent.
So which is it? Were they malicious or just incompetent? Probably it was both. In either case do you really want to put all of your life savings under their domain? I don’t. But that’s exactly what relying on TIPS for inflation protection does. That’s the heart of the business intuition case for avoiding them. The people making the decisions likely can’t be trusted to act in your interest in regards to high inflation when it is a problem. This is not unique to the U.S., other countries where high inflation has been a problem react very similarly in terms of politics and misdirection.
So back to TIPS, the “perfect” inflation hedge…
Inflation is a political football. It involves finger pointing, blaming, and inaction until it finally gets so bad the markets force a solution one way (by punishing the currency) or another (by getting those responsible removed from office so the currency can regain strength under new leadership). But consider that TIPS are linked to the Consumer Price Index (CPI). The CPI is also controlled by the policymakers. That makes TIPS a political football by extension. Any debate on inflation is going to trickle down to anyone holding TIPS but they have no control over the situation.
Is there a mathematical model that can show this? No. Is there a bit of business intuition based on past history that should be used? Absolutely! We shouldn’t be naive about these risks.
Some may argue with me about this and call it a conspiracy and such. However, we are talking about inflation risks and assessing likely outcomes of high inflation if it returns to the U.S. for strategic investing and planning purposes. A likely outcome is, quite possibly, a variation of the theme that happened in the 1970s with respect to high inflation. That could very easily include misrepresentations of the CPI, policies enacted to impact inflation payments in other ways (a “windfall” tax, etc.) or other games during the crisis.
I don’t want my inflation protection to be a political negotiating point during a crisis. I’d rather be on the sidelines watching the game unfold and not an active participant, thank you very much. Any product relying on the CPI to provide inflation adjustment is just begging to be abused in this situation. Sorry to disappoint. We’re just theorizing here, but based on past actions it is something to seriously consider. My spider-sense just tingles too strongly when I think about TIPS saving me from high inflation.
My observation is that for low and steady inflation, stocks and bonds are perfectly fine and can keep up and give good real returns. But if inflation is very bad then these assets will fail and you better have some hard assets in your portfolio like gold and not TIPS to save you. Gold is immune from a lot of political inflation shenanigans that are likely to roast TIPS holders when they need that protection the most.