Deflation strikes hard in January: What does it mean for TIPS and I Bonds?

The Consumer Price Index for All Urban Consumers (CPI-U) declined 0.7% in January on a seasonally adjusted basis, the U.S. Bureau of Labor Statistics reported today. Over the last 12 months, U.S. inflation decreased 0.1%.

Gasoline prices were the major factor in the decline, dropping a whopping 18.7% in January. Over the last 12 months, gasoline prices have fallen 35.4%. Food prices were stable for the month, while apparel costs rose 0.3%. Medical care commodities fell 0.3%, after rising 0.9% in January.

Core inflation – which strips out food and energy – was up 0.2% in January and 1.6% over the last six months. This indicates that even without the steep drop in energy prices, overall inflation has been muted over the last year.

Holders of TIPS and Series I Savings Bonds are also interested in the non-seasonally adjusted CPI-U, which is used to adjust the principal balance of TIPS and set future interest rates for I Bonds. In January, the inflation index stood at 233.707, a drop of 0.47% from December.

I have updated my Tracking Inflation and I Bonds page with these new numbers.

What this means for TIPS. January’s inflation index of 233.707 sets the TIPS principal adjustments through March 31, 2015. It means that accrued principal balances of all TIPS you own will be declining over the next two months. These balances go up with inflation and decline with deflation.

As an example, take a look at CUSIP 912810QV3, a 30-year TIPS that was issued in February 2012. Let’s say you bought $10,000 of that TIPS at the original auction. On Aug. 31, 2014, its inflation index stood at 1.05474, meaning your principal balance had risen to $10,547.74. But since then, we’ve entered a deflationary period. Today’s inflation index for that TIPS is 1.03981, meaning its balance has fallen to $10,398.10. On March 31, the index will be 1.03444, dropping the accrued balance to $10,344.40.

This TIPS has a coupon rate of 0.750% which it pays on the accrued principal balance. So even your interest earned has been declining during this period of deflation.

Grim news, but rising gasoline prices in February should mark a turn-around to at least moderate inflation this month.

What this means for I Bonds. The same inflation index is used to set the future interest rate paid by I Bonds. The next adjustment in this variable rate comes May 1, based on inflation from September 2014 to March 2015. Here is what has happened so far:

Current inflationIt’s extremely unlikely that inflation in February and March will be enough to turn around a four-month decline of 1.82%. So on May 1, I Bonds are likely to get a sharply negative inflation-adjusted rate, which is added to the I Bond’s fixed rate to determine the composite rate. So I Bonds with a positive fixed rate could see that fixed rate wiped out when the negative inflation-adjusted number is added in. However, the worst possible outcome is that the I Bond pays zero percent interest for six months. The I Bond’s principal balance is unaffected.

Strangely enough, a concentrated period of deflation is a ‘positive’ thing for holders of I Bonds, because the principal balance cannot decline and the composite interest rate can’t fall below zero. So, go ahead, dump a lot of deflation into one six-month period — a bigger negative number is no worse than a tiny negative number. If prices turn around in the next adjustment period, which seems likely, I Bond holders will get a much higher inflation-adjusted interest rate.

TIPS versus I Bonds. When you buy a TIPS at auction, you get a ‘real yield to maturity’ – and that yield will never change. If your yield to maturity was 0.50%, that means you are going to earn 0.5% over inflation. Period. If we see deflation of 1%, your principal balance falls by 1%, you earn your coupon and the result is 0.5% over inflation.

With I Bonds, in a time of 1% deflation, the ‘real’ return is at least 1%, because the I Bond holds its current value, even when it earns zero interest. If deflation hit 5%, the I Bond’s real return would be 5%. See my previous post: TIPS versus I Bonds during deflationary¬†times.

Here is the inflation trend over the last 12 months:

Inflation year

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3 Responses to Deflation strikes hard in January: What does it mean for TIPS and I Bonds?

  1. Len says:

    Seems those who purchase inflation protected securities frequently don’t consider the possibility of deflation. As you demonstrate the “lowly” I bond has its place in our portfolios. Will the sudden spate of wage increases by retailers lead to inflation? Does the downward spiral of oil prices foretell worldwide recession/depression? At least there is one investment vehicle we may feel is immune.

  2. tipswatch says:

    Oil prices did have a bit of a rebound in February, so that deflationary pressure eased this month. The Walmart wage decision – which was followed by other retailers – might be a first sign of a bit of wage inflation. Eventually …

  3. Pingback: Deflation breaks (slightly), as US inflation rises 0.2% in February | Treasury Inflation-Protected Securities

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