I was out of town last week and didn’t get a chance to write about the U.S. inflation rate in July, which was unchanged from June, in other words … zero inflation in July.
This is the ‘headline’ inflation rate – the Consumer Price Index for All Urban Consumers (CPI-U) – which is the rate that determines principal adjustments for holders of TIPS and will help to determine the next 6-month adjustment in the inflation-adjusted interest rate for I Bonds.
The core CPI – which excludes volatile food and energy prices – rose by only 0.1 percent in July. The core rate is the one the Fed watches closely, but doesn’t directly affect interest rates for TIPS and I Bonds.
Over the last 12 months, headline inflation has increased a meager 1.4 percent, and core inflation was up 2.1 percent. The trend since spring has been remarkable:
It’s great that inflation is muted, but for holders of TIPS and TIPS mutual funds this is a four-month double whammy. Many people buying TIPS in the last year have accepted yields to maturity that are negative to inflation. Since April, they have also seen their principal balance decline by 0.3%. Ouch.
I Bond holders also might be affected come November, when the new six-month interest rate will be unveiled. The I Bond inflation component is based on the difference between the March and September levels of the CPI-U. In March, inflation was 0.3%, so for now, I Bond holders are looking at a zero interest rate for six months (November 2012 to April 2013), but we’ll have to wait for the August and September inflation numbers to know for sure.
Even at zero interest, though, I Bonds might be preferable to TIPS paying a negative real yield at a time of zero inflation. Negative plus zero = negative.
Prediction. We can expect the buying appetite for I Bonds to dry up completely if they pay a zero base rate and a zero inflation adjustment beginning in November.
Yes, I Bond inflation component could go to zero for some time, but with a $10,000 per person annual limint on purhcase of I Bonds, this is still a good time to build up a position in I Bonds. I just cannot believe that infllation will not rear its ugly head down the road.
With the drought in the Midwest, time will tell if either the TIPS or iBonds perform better next year in their traditional role as a hedge against inflation. It’s certainly hard to rationalize purchasing TIPS with paltry nominal rates, a negative yield to maturity and the possibility of a loss of principle due to deflation. This time last year, the composite rate for iBonds stood at 4.6%. This was mostly due to a spike in gas prices. It remains to be seen how large an effect the drought will have on food prices and it’s component in the CPI-U.
Jimbo, gas and food prices definitely appear to be heading up, so I agree the trend of zero inflation is likely to reverse, at least a bit. Last year’s generous I Bond rate was also an anomaly caused by gas prices as you note. While gas prices dipped this year, they are again heading up, and if the Fed does decide to launch another major stimulus this fall, commodity and energy prices could rise sharply. Then TIPS would be a nice safety hedge.
Does this mean raise-your-rate CD’s are becoming more attractive?
Ronald, yes, think a raise-your-rate CD should be considered. Ally is offering a 2-year raise-your-rate CD with an opening rate of 1.14%. But consider this: If you bought an I Bond today, you would get 2.2% interest rate for the first six months, and then at the worst case 0.0% for the next six months, meaning you’d get 1.1% for a year. You could then sell the I Bond with zero penalty (the three-month interest penalty would equal zero), so in effect you get a raise-your-rate I Bond with 1.1% for the first year.
That makes the Ally CD versus I Bond decision very interesting.
(Possible problem: A year from now I Bonds might still be paying 0%, and you’d have to reinvest somewhere else.)