It has been said that it is not just inflation that is damaging, but unexpected inflation. After all, if inflation could be accurately predicted, there would not be the subtle transfer of wealth between parties to agreement (ex-lender and borrower). In the U.S., unexpected inflation helped spawn the creation of government issued inflation protected securities, called Treasury inflation protected securities (TIPS).

TUTORIAL: All About Inflation

Because inflation can be so damaging - and so unexpected - investors should have some portion of their fixed income portfolios in TIPS to ensure a "real return", but they are only part of the solution. This article will review the history and mechanics of TIPS, explore a few underlying components of TIPS operations that may leave the investor with a TIPS letdown and look briefly at an economic controversy that may help the investor think differently about protecting the real return of his or her portfolio.

History and Mechanics of TIPS
In the late 1990s, the U.S. Treasury followed the lead of several other governments in creating a real return, or inflation-adjusted, bond. Bond holders have always faced many risks to the return of their principal and interest, and the creation of TIPS sought to reduce inflation risks for Treasury investors. (For related reading, see What You Should Know About Inflation.)

It is important to realize that the adjustment mechanism that is used by TIPS is based on the Bureau of Labor Statistics' (BLS) Consumer Price Index for all Urban Consumers (CPI-U) headline inflation figure. As such, it includes the historically volatile components of food and energy prices. According to "Investment Analysis & Portfolio Management" (2002), a book by Frank Reilly and Keith Brown, because inflation is generally not known until several months after the fact, the index value used has a three-month lag built in. For example, for a bond issued on June 30, 2003, the beginning base index value used would be the CPI value as of March 30, 2003. Following the issuance of a TIPS bond, its principal value is adjusted every six months to reflect the inflation since the base period. In turn, the interest payment is computed based on this adjusted principal, that is, the interest payments equal the original coupon times the adjusted principal. (To learn more, read The Consumer Price Index Controversy and The Consumer Price Index: A Friend To Investors.)

CPI-U's Issues
With a better background into the indexing system used in the payment of TIPS interest, the investor needs to shift focus to how CPI-U is calculated; after all, its calculation determines whether your TIPS payment truly matches the increase in prices that may occur as a result of inflation.

Owner's Equivalent Rent
It is easy for investors to take the released CPI figures for granted, trusting that the BLS knows best how to measure inflation. Therefore, just how complicated the task of calculation actually is may come as quite a surprise. This is because there are many subjective aspects to putting the CPI together.

One very important example is that of the estimation of housing expense. Housing costs are the largest expense for many families, but the cost of housing is not a direct function of housing prices; it is based upon a creation called owner's equivalent rent (OER). Owners are queried periodically as to what level of rent they would charge to prospective tenants. Housing's proportion in the makeup of CPI is greater than 25%, so these numbers play a big role in the final CPI-U reading.

Treatment of Quality Improvements
Another rather subjective aspect of CPI-U calculation is that there is no mechanism for measuring quality improvements in the products and services that are in the marketplace. Furthermore, the BLS (through its retailer rotation practice) might measure an uptick in the price index if the new store carries the exact same product at a higher price. The assumption here is that the consumer has benefited by a non-price factor; the customer is assumed to have received better service in exchange for the higher price.

CPI: Overstated or Understated
Some argue that CPI overstates inflation, and thus understates economic growth via the following relationship: Nominal GDP - Inflation = Real GDP. Others believe that CPI understates some of the more subtle aspects and costs that inflation's mere presence introduces.

Steven Horwitz, in his article "The Costs of Inflation Revisited" (The Review of Austrian Economics, 2003), introduces two broad categories of inflation's costs: one results in direct costs, the other he terms coping costs. The direct costs include the errors made by investors and corporate managers due to uncertainty over the true value of a dollar. Coping costs involve the fact that CPI does not account for the time resources that are spent by investors and corporate managers trying to deal with, or compensate themselves for, inflationary effects. Horwitz introduces the example of individuals directing time toward hiring and meeting with financial professionals to form financial strategies, which are needed, in part, because of inflation. The same principle applies to corporate managers in the management of their treasury dollars and cash balances. While these concepts highlight inferred, rather than discrete, costs, the idea is that extra inefficiencies are created within the market outside of changes in interest rates.

Investors should diversify their inflation coping methods. While the use of TIPS may be part of the solution, it may also be advisable to employ other methods and instruments, such as commodities, metals and managed futures, which may provide further diversification for the investor's portfolio.

To learn more about TIPS, read Treasury Inflation Protected Securities.

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