Treasury Inflation-Protected Securities

U.S. ‘headline’ inflation – formally known as the Consumer Price Index for All Urban Consumers – rose 0.3% in December on a seasonally adjusted basis, the Bureau of Labor Statistics reported this morning.

The number – higher than in recent months – matched the consensus estimate and was triggered by higher costs for energy, apparel and shelter. Over the last 12 months, headline inflation increased 1.5%. Read the full BLS report.

Holders of TIPS and I Bonds are more interested in the non-seasonally adjusted CPI-U, which is used to determine principal adjustments on TIPS and future inflation-adjusted interest rates on I Bonds. Non-seasonally adjusted CPI-U was unchanged in December, and up 1.5% over the last 12 months.

The gasoline index rose 3.1%, and the fuel oil and electricity indexes also increased, resulting in a hefty 2.1% increase in the energy index. (Energy prices had fallen in October and November.) Apparel was up 0.9% and the shelter index rose 0.2% in December. Food was up a tame 0.1%.

Several factors helped to hold down inflation, such as a decline of 0.8% in medical care commodities and a drop of 0.2% for used cars and trucks.

Core inflation – which strips out energy and food – was up 0.1% in December and 1.7% for the last 12 months.

2012-13, years of weak inflation. The BLS reported: “CPI rose 1.5 percent in 2013 after a 1.7 percent increase in 2012. This is lower than the 2.4 percent average annual increase over the last ten years. This is the first time the CPI has gone up less than 2.0 percent for consecutive years since 1997-98.”

Here is the trend in headline inflation over the last year:

Minutes from the Federal Reserve Open Market Committee always get a lot of attention, but the minutes from December’s meeting are especially important, because at that meeting the Fed finally launched a slowdown of its bond-buying economic stimulus program.

Embedded in those minutes was intriguing discussion on whether the Fed’s near-eternal quantitative easing was causing a bubble in the stock and housing markets. After all, the S&P 500 was up about 28% in 2013, and U.S. housing prices rose about 13.5%.

The Wall Street Journal jumped on this with a story headlined: ‘Fed Minutes: Bubble Risks Drawing Attention‘. The story quoted Dan Greenhaus, chief global strategist at brokerage firm BTIG LLC, as saying, “The Fed is looking for evidence that they may be creating asset bubbles. That’s better than not looking.”

Read the full text of the Federal Reserve minutes and you can decide for yourself. Here is my summary of the core topics from the minutes, released Wednesday:

• At least a little risk of a bubble? The Fed committee considered its aggressive bond-buying program, which lowers long-term interest rates and propels values of stocks, and said:

Participants were most concerned about the marginal cost of additional asset purchases arising from risks to financial stability, pointing out that a highly accommodative stance of monetary policy could provide an incentive for excessive risk-taking in the financial sector.

• Do we really know what we are doing? Um … not sure.

It was noted that the risks to financial stability could be somewhat larger in the case of asset purchases than in the case of interest rate policy because purchases work in part by affecting term premiums and policymakers have less experience with term premium effects than with more conventional interest rate policy.

• How do we get out of this? Ah yes. How do you yank away this economic stimulus, which has boosted the housing and stock markets for years?

(P)articipants noted that ongoing asset purchases could increase the difficulty of managing exit from the current highly accommodative policy stance when the time came. Many participants, however, expressed confidence in the tools at the Federal Reserve’s disposal for managing its balance sheet and for normalizing the stance of policy at the appropriate time.

• OK, but is this even working? Another great question.

A majority of participants judged that the marginal efficacy of purchases was likely declining as purchases continue, although some noted the difficulty inherent in making such an assessment. A couple of participants thought that the marginal efficacy of the program was not declining,

• The economy is doing fine.

The information reviewed for the December 17-18 meeting indicated that economic activity was expanding at a moderate pace. … The unemployment rate declined, on net, from 7.2 percent in September to 7.0 percent in November. … (T)he forecast for growth in real gross domestic product (GDP) in the second half of this year was revised up a little.

• Inflation isn’t high enough. The Fed isn’t happy with the 1.2% rise in CPI over the last 12 months. It wants 2% or higher.

Inflation continued to run noticeably below the Committee’s longer-run objective of 2 percent, but participants anticipated that it would move back toward 2 percent over time as the economic recovery strengthened and longer-run inflation expectations remained steady. … (I)nflation was projected to be subdued through 2016.

• Housing is slowing down. This is what happens when prices rise and long-term interest rates increase.

The pace of activity in the housing sector appeared to continue to slow somewhat, likely reflecting the higher level of mortgage rates since the spring. … Sales of existing homes and pending home sales decreased further in October, although new home sales rose in October after falling markedly in the third quarter.

• Interest rates are rising, even when you try to hold them down. It works that way sometimes.

Mortgage rates rose over the intermeeting period to levels about 100 basis points above their early-May lows.

• American consumers are getting their mojo back, thanks to higher stock and housing prices.

Consumer spending appeared to be strengthening, with solid gains in retail sales in recent months and a rebound in motor vehicle sales in November. … (S)pending was being supported by gains in household wealth associated with rising house prices and equity values, the still-low level of interest rates, and the progress that households have made in reducing debt and strengthening their balance sheets.

• Congress and the White House are behaving.

(A) number of participants observed that the prospect that the Congress would shortly reach an accord on the budget seemed to be reducing uncertainty and lowering the risks that might be associated with a disruptive political impasse.

• Let the tapering begin, with qualms. The Federal Reserve actually set a plan to lower its bond-buying stimulus, and the world did not end.

(M)ost participants saw a reduction in the pace of purchases as appropriate at this meeting and consistent with the Committee’s previous policy communications. … However, several participants stressed that the unemployment rate remained elevated … and that the projected pickup in economic growth was not assured. Some participants also questioned whether slowing the pace of purchases at a time when inflation was running well below the Committee’s longer-run objective was appropriate.

• Can we please have a plan?

A few proposed that the Committee lay out, either at this meeting or subsequently, a more deterministic path for winding down the program or that it announce a fixed amount of additional purchases and an expected completion date, thereby reducing uncertainty about the trajectory of the purchase program.

• Finally, a decision. The tapering door opens, a crack, but it is now open.

(T)he Committee agreed that, beginning in January, it would add to its holdings of agency mortgage-backed securities at a pace of $35 billion per month rather than $40 billion per month, and add to its holdings of longer-term Treasury securities at a pace of $40 billion per month rather than $45 billion per month.

This blog is focused on Treasury Inflation-Protected Securities and I Bonds, both inflation-protected investments. So you might wonder why I’ve been ‘all excited’ about a 3% 5-year CD being offered by the Pentagon Federal Credit Union through Jan. 31, 2014.

One word answer: Math.

The bigger picture is that my wife and I try to keep an asset allocation of 40% stocks and 60% bonds, with a heavy allocation of bonds in tax-deferred accounts. But that is just the ‘asset type’ allocation. In addition, I monitor our ‘inflation-protected allocation‘, which I’d like to be about 15% to 20%.

I also try to monitor our ‘asset safety allocation‘, which I have written about before, and it looks something like this:

• 10% Highest risk: International stock funds, smaller-cap stock funds
• 30% Higher risk: Total stock market funds, S&P 500 funds, etc.
• 35% Lower risk: Broadly diversified bond funds, TIPS funds, municipal bonds
• 25% No risk: TIPS, I Bonds, insured bank CDs, Treasurys held to maturity

Those numbers might vary, and in fact it has been hard to keep the no-risk category up to the desired level with yields so low. I Bonds are especially helpful, because they are tax-deferred but not in a tax-deferred account. The only problem with I Bonds is the yearly purchase cap ($10,000 per person per year, plus $5,000 possible as a tax refund.).

Everywhere you turn today you see articles warning about the dangers of bond investments. And my answer to that is: Find safety. By buying TIPS, I Bonds and insured CDs – and holding to maturity (whatever you choose for I Bonds) – you completely eliminate risk. Your principal balance is not going down.

So along comes the PenFed CD, federally insured for 5 years paying 3%. It fits into the ‘no risk’ category,  it’s in the fixed-income category, it can be purchased in a tax-deferred account, and the insured limit is a lofty $250,000. But it does not offer inflation protection.

So how does it compare with a 5-year TIPS, an I Bond or a traditional Treasury? Here’s the math, with the winning investment highlighted for each inflation rate:

Conclusion: This 5-year CD, especially in a tax-deferred account, can be a nice supplement to your I Bond investment this year. And since the I Bond fixed rate of 0.2% is intact through April 30, there is no rush to buy I Bonds. The PenFed offer lasts through Jan. 31, though, so time is limited on that investment.

I’ve been watching to see if the Pentagon Federal Credit Union would extend its 3% five-year CD into 2014, and indeed, it has extended it until Jan. 31. I opened a $5 savings account there in December, hoping to put my entire 2014 IRA contribution in this account.

I’ll be reporting more on this later this week. For now, check it out on http://www.penfed.org.

Update, Jan. 2:  Last month, I created a PenFed savings account with $5 in it and my application was approved. My father served in the Navy and later worked in the Defense Department as an auditor, so that was my military connection. But even if you have no military connection, you can get a PenFed account by joining (for a small one-time fee) the National Military Family Association or Voices for America’s Troops. Here are details.

Once you are member, you can open an IRA account with a $25 investment (or you can fully fund it with one investment). The IRA application process is just a little daunting. You need to download the IRA information package, which includes the forms you’ll need.

I am going to fully fund my 2104 IRA with one investment in the 5-year CD, so I will send in a check with the completed form. If all goes well, the account should be created in a few days, and I will update again.

If you are considering transferring IRA assets into PenFed, the information packet also includes those forms.

Update Jan. 6: My IRA account at PenFed is open and my 2014 IRA contribution is earning 3%, tax-deferred, for the next 5 years. Very easy process, after all.