U.S. inflation went flat in July: What it means for I Bonds, TIPS and Social Security COLA

Posted on August 10, 2022 by Tipswatch

Core inflation continues at 5.9%, an unsustainable rate.

By David Enna, Tipswatch.com

I warned you: Inflation numbers are notoriously fickle in the summer months, and so here we go: All-items U.S. inflation increased 0.0% in July on a seasonally adjusted basis, the Bureau of Labor Statistics reported today. The year-over-year number dipped to 8.5%, down from June’s 41-year-high of 9.1%.

Inflation was expected to dip in July because of a strong drop in gasoline prices, a trend that continues in August. But today’s inflation numbers were well below the consensus estimates of 0.2% for all-items and 8.7% for the annual rate. Core inflation, which removes food and energy, came in at 0.3% for the month and 5.9% for the year, also below consensus estimates.

For American consumers, this is good news. We seem to have finally passed “peak inflation” and prices are heading down. But keep in mind that annual inflation is still running at 8.5%, a dangerously high number.

The BLS noted that gasoline prices fell 7.7% in July, after increasing 11.2% in June, and still remain 44% higher than a year ago. The decline in gas prices helped offset a 1.3% increase in the cost of food at home, now up a painful 13.1% over the last year. June was the seventh consecutive month where food prices increased 0.9% or more.

Other notable trends:

  • Shelter costs increased 0.5% in July and are up 5.7% year over year. The rent index rose 0.7% in July. The BLS said shelter costs accounted for about 40% of the increase in core inflation.
  • Costs for used cars and trucks dipped 0.4%, but are still up 6.6% over last year’s highly elevated prices.
  • Prices for new vehicles increased 0.6% and are up 10.4% for the year.
  • The index for natural gas declined in July after sharp recent increases, falling 3.6%. (Let me know when you see your natural gas bill decline in response.)
  • The medical care index rose 0.4% in July after rising 0.7% in June, and is now up 5.1% year over year.
  • The index for airline fares fell sharply in July, decreasing 7.8%.

So, while overall inflation was down in July, the complete picture remains complex. Gas prices down, food prices up and everything else … mostly up, with core inflation continuing to run at 5.9%. Here is the 12-month trend for all-item and core inflation, showing that while overall inflation seems to have peaked, core inflation appears locked in at around 6.0%:

What this means for TIPS and I Bonds

Investors in Treasury Inflation-Protected Securities and U.S. Series I Savings Bonds are also interested in non-seasonally adjusted inflation, which is used to adjust principal balances of TIPS and set future interest rates for I Bonds. For July, the BLS set the CPI-U index at 296.276, down 0.01% from June’s number of 296.311.

For TIPS. July’s inflation report means that principal balances for all TIPS will decline by 0.01% in September, after rising 1.1% in July and 1.37% in August. Over the year ending in September, TIPS principal balances will have increased 8.5%. Here are the new September Inflation Indexes for all TIPS.

For I Bonds. The July report is the fourth of a six-month string that will determine the I Bond’s new variable rate, which will be reset November 1. As of now, inflation has increased 3.05% in that four-month stretch, which would translate to a variable rate of 6.1%, very attractive but well below the current rate of 9.62%. Two months remain, and a lot can happen in two months. Stay tuned. Here are the numbers so far:

View historical numbers on my Inflation and I Bonds page.

What this means for the Social Security COLA

The July inflation report is the first of three — for July to September — that will set the Social Security Administration’s cost of living adjustment for 2023. The SSA uses a three-month average of a different index, the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W), to set its COLA.

For July, the BLS set CPI-W at 292.219, an increase of 9.1% over the last 12 months. However, CPI-W actually fell 0.1% for the month. But remember, it will be the average of July to September inflation indexes — compared to the same three-month average a year ago — that will determine the Social Security COLA. A year ago, that average was 268.421. July’s number was 8.9% higher. If we have zero inflation in August and September, the COLA will be 8.9%

In a recent article, I predicted that the 2023 COLA would get an increase of 9.9% to 10.1%. That could still happen, but the current trend in gas prices should push the number lower. We’ll see. Last year, July inflation ran fairly hot (about 0.5%) but then cooled off in August and September. Here are the historical numbers used in this COLA calculation:

View historical calculations on my Social Security COLA page.

And here is my updated projection for the Social Security COLA in 2023, factoring in the slight deflation in the July index:

What this means for interest rates

The Federal Reserve can’t steer away from its inflation-fighting course, but the July report gives it a little breathing room. It looks like year-over-year inflation has finally peaked. But notoriously volatile gas prices are the primary reason for the dip, and food prices continue to soar. It’s significant that for the first time in many months, inflation came in under consensus estimates. The stock market is happy, with the S&P 500 index already up about 1.6% at 9:35 a.m. EDT.

There should be no “declaring victory.” Inflation remains very close to a four-decade high and cannot continue even at the core rate of 5.9%. Reducing inflation will continue to be Job No. 1 for the Fed. Could we see a 50-basis-point increase in short-term rates in September, instead of 75? I think July’s inflation report made that more possible.

From this morning’s Wall Street Journal report:

Rapidly rising prices have become persistent following a surge in inflation from goods, energy and food, said Greg Daco, chief economist for EY-Parthenon, a consulting firm.

“That divergent trend shows there’s a breadth of inflation in that housing inflation and service-sector inflation remain elevated,” he said, adding price pressures in those areas could linger. “And those tend to be stickier than goods, which can and will start to reverse.” …

“Even if headline inflation slows on account of weaker energy prices but core inflation is stubbornly high, the Fed is likely to maintain its tightening bias as it will be concerned about high inflation being entrenched in consumer price expectations,” said Blerina Uruci, U.S. economist at T. Rowe Price Group Inc.

The inversion in nominal yields continues this morning, with the 26-week Treasury yielding 2.99%, the 2-year at 3.11% and the 10-year at 2.72%. The bond market is predicting economic weakness, which will make the Fed’s job even more difficult.

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Feel free to post comments or questions below. If it is your first-ever comment, it will have to wait for moderation. After that, your comments will automatically appear.

David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can be purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.

Posted in Federal Reserve, I Bond, Inflation, Investing in TIPS, Social Security | 40 Comments

Don’t go ballistic over the way TreasuryDirect reports I Bond interest

Posted on August 9, 2022 by Tipswatch

Confusing? Aggravating? Of course, but also correct.

By David Enna, Tipswatch.com

I’ve had several communications recently from readers who are new to U.S. Series I Savings Bonds and freaking out by the apparently low interest payments reported so far on the TreasuryDirect website. Here’s an example from this week:

After fourteen months, the value of my (March) 2021 bond has increased only 3.84%, or by $384. If the bonds truly tracked inflation, they would have increased by at least $850 – one year at 8.5% plus another two months’ interest. … I suspect the 6-month calculation period is the clever “trick” by which the government sees offering these bonds as worthwhile. It is what gives the house the advantage. … I feel swindled.

First of all, and most importantly, the Treasury is not swindling anyone. I Bonds do accurately track official U.S. inflation, but investors need to keep in mind that the I Bond’s current variable rate is set by inflation six months in the past. Eventually, if you hold them, all I Bonds catch up to current U.S. inflation (either up or down).

This particular reader purchased $10,000 in I Bonds in March 2021 and then $10,000 again in March 2022. In my opinion, those were excellent investments. But the reader has looked at the TreasuryDirect website and sees his two I Bonds have earned only $500 in interest so far, when current U.S. inflation is running at 9.1%. He asks: “Why?” (And he is not alone. I get this sort of question several times a week.)

Note: I wrote an updated article on the Treasury’s interest rate calculations. View it here.

What is happening here?

The key issue is that I Bonds cannot be redeemed for one year, and I Bonds redeemed from year one until year five will lose the last three months of interest. When you look at your I Bond earnings on TreasuryDirect — if you haven’t yet held them 5 years — the interest that TreasuryDirect reports WILL NOT include the latest three months of interest.

A second issue is that when I Bonds are issued, they earn the current variable rate for a full six months before transitioning to the next variable rate, and so on, every six months. Eventually, all I Bond holders get exactly the same variable rates, but the trigger dates are staggered by the month of issue.

In the case of this reader, the I Bonds were purchased in March, which means that the variable rate will update each September and March. This is crucial for understanding the interest calculation.

Example one: I Bond issued in March 2021

I used TreasuryDirect’s Savings Bond Calculator to get the current value of a $10,000 I Bond issued in March 2021. Because the calculator is supposedly “only” for paper I Bonds, I had to enter $5,000 twice into the calculator. Here is the result:

The reader was correct in noting that this I Bond had only earned $384 in reported interest since March 2021. Why is that? One factor is that in March 2021, the I Bond’s composite rate was 1.68% (fixed rate of 0.0% + variable rate of 1.68%) for a full six months. And now I will let my chart take over:

Well, look! … This March 2021 I Bond has not yet started earning the current 9.62% composite interest rate because it is still in the six-month period earning 7.12% interest, though this month. In September, the I Bond will begin earning 9.62%, earning at least $482 over the September to February period.

My total of $380 differs from TreasuryDirect’s $384 because of compounding, but close enough.

The I Bond so far has earned $558 in interest (actually a little more with compounding), but TreasuryDirect will only report $384 because it will always eliminate the last three months of interest for an I Bond that hasn’t yet hit the 5-year mark.

A bit of advice: Before redeeming any I Bond before 5 years, make sure to check the term of the current composite rate. In this March 2021 example, you wouldn’t want to sell the I Bond until three months after the 9.62% rate runs its course. That would be June 2023, at the earliest, but the next variable rate could be nearly as high.

Example two: I Bond issued March 2022

Here is TreasuryDirect’s calculation:

This one is a lot simpler. TreasuryDirect says that this I Bond has earned $116 interest so far. Again, the composite rate is 7.12% through August, and then will transition to 9.62% from September to February.

Here’s my calculation of how this interest was determined:

In this case, my calculation matches the TreasuryDirect number because no compounding has yet taken place for this I Bond. The first accrual will be in September, so the principal balance will climb a bit just as the 9.62% interest rate kicks in.

Final thoughts

I may be weird, but I actually trust the way the Treasury reports my I Bond interest, but I know all about the quirks of the three-month penalty and staggered variable rates. I recently redeemed EE Bonds we purchased in 1992 and the Savings Bond Calculator nailed our proceeds to the penny. The Treasury is not looking to cheat Savings Bond investors, I am certain of that.

Not everything in life is a conspiracy to cheat you. Savings Bonds are a trustworthy investment.

• Confused by I Bonds? Read my Q&A on I Bonds

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Feel free to post comments or questions below. If it is your first-ever comment, it will have to wait for moderation. After that, your comments will automatically appear.

David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can be purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.

Posted in Cash alternatives, I Bond, Inflation, Savings Bond | 53 Comments

Is the Federal Reserve really tightening? So far, not so much.

Posted on August 7, 2022 by Tipswatch

Quantitative tightening will have to ramp up in coming months if the Fed wants to bring U.S. inflation down.

By David Enna, Tipswatch.com

The basic monetary rule of the last two decades has been this: When the economy slips lower and the stock market stumbles, the Federal Reserve steps in with aggressive stimulus. But when the economy is thriving, and the stock market is soaring, the Fed sits on the sidelines and watches.

That rule has been crushed in 2022, because U.S. inflation has soared to a 41-year high of 9.1%. Now the Fed has been forced to act, and it is aggressively raising interest rates and beginning to reduce its massive balance sheet of Treasurys and mortgage-backed securities.

Amassing the Fed’s current $8.8 trillion balance sheet has taken more than a decade in a process known as quantitative easing. What is quantitative easing? Here is a concise definition from Investopedia:

Quantitative easing (QE) is a form of monetary policy in which a central bank, like the U.S. Federal Reserve, purchases securities from the open market to reduce interest rates and increase the money supply. … As money is increased in an economy, the risk of inflation looms.

When the Fed reduces its balance sheet, it uses a process known as quantitative tightening. Again, here is the Investopia’s concise definition:

Quantitative tightening (QT) refers to monetary policies that contract, or reduce, the Federal Reserve System’s balance sheet. This process is also known as “balance sheet normalization.” In other words, the Fed (or any central bank) shrinks its monetary reserves by either selling Treasuries (government bonds) or by letting them mature and removing them from its cash balances. This removes liquidity, or money, from financial markets.

On March 23, 2022, the Federal Reserve’s balance sheet topped off at $8.96 trillion, an increase of 282% over the total of $2.44 trillion in January 2011. Since March, the Fed has begun to raise interest rates and to allow Treasurys and mortgage-backed securities to mature without reinvestment. Now, as of Aug. 2, 2022, the balance sheet stands at $8.87 trillion, a reduction of just 1% in four months.

I repeat, a reduction of 1% after an increase of 282% over a stretch of 11 years. This is what the Federal Reserve does when it implements quantitative tightening, at least so far into this inflationary crisis. Here is a look back at the Fed’s moves to “ease” and “tighten” over the last 11 years:

Click on the image for a larger version.

There are so many things to consider in this chart.

  • Note that the easing periods — when the Fed was adding to its balance sheet and increasing the U.S. money supply — lasted longer and moved higher very quickly.
  • The Fed increased its balance sheet by 84.8% from January 2011 to November 2014, then essentially kept it stable from 2014 until March 2018.
  • The one period of quantitative tightening that is completed lasted from about March 2018 to September 2019, only 17 months. That 2018-19 tightening resulted in a reduction of only 13.1%.
  • Then in late 2019 through March 2022, the Fed increased its balance sheet by an astounding 138.3%.
  • Now, with tightening beginning again, the Fed is taking a slow-motion approach, reducing the balance sheet only 1% over four months.

Over this same period, here is the trend in the U.S. money supply, as defined by M2:

Click on the image for a larger version.

And to complete the picture, here is the trend in the annual U.S. inflation rate, by month, over that same time period:

Click on the image for a larger version.

Logical conclusion: Increases in the Fed’s balance sheet, especially in the period after 2018 through the pandemic — and combined with aggressive direct-to-taxpayer stimulus from Congress — resulted in a strong surge higher in both money supply and U.S. inflation. To solve today’s dangerous inflation problem, the Fed will have to get serious about reducing its balance sheet, running the risk of weakening the U.S. economy.

But so far, the Fed hasn’t seriously addressed its balance sheet, which has probably resulted in a weird combination of effects: 1) allowing longer-term interest rates to drift lower, and 2) allowing the stock market to surge off its bear market lows.

Barron’s published a story yesterday with a great headline: “The Fed Is About to Ramp Up Balance-Sheet Shrinkage. It May Get Dicey.” The article makes the point that the Fed’s half-hearted balance sheet reduction so far is barely being noticed by the markets. From the article:

When the central bank began QT in June, it set out to partially unwind roughly $4.5 trillion in quantitative easing, or QE, that was conducted in response to the pandemic. The Fed started by letting up to $30 billion in Treasuries and $17.5 billion in mortgage-backed securities, or MBS, roll off its balance sheet, as opposed to reinvesting the proceeds. Starting next month, those caps will rise to $60 billion and $35 billion, respectively, meaning the pace of balance-sheet runoff is about to double. Fed Chairman Jerome Powell has suggested that QT would go on for two to 2½ years, implying that the Fed’s $9 trillion balance sheet would shrink by roughly $2.5 trillion.

Barron’s points out that the Fed has attempted quantitative tightening only once before, in the 2018-19 period, and even though that tightening wasn’t aggressive, it resulted in disruptions to the U.S. bond market. More from the article, with thoughts from Joseph Wang, former senior trader on the Fed’s open markets desk.:

September and beyond is when Wang warns something is apt to break, not unlike what happened the last time the Fed embarked on QT, and chaos in the repo market prompted an early end to the program. …

And from Solomon Tadesse, head of quantitative equities strategies North America at Société Générale:

… in order to bring inflation back to 2%, the Fed needs to shrink its balance sheet by about $3.9 trillion — significantly more than what investors expect, Tadesse says. By his calculations, QT alone would amount to about 4.5 percentage points in additional rate hikes.

“I don’t think there is appreciation for QT, by markets or the Fed,” Tadesse says. “In the end, if QE mattered, so will QT,” he says, referring to the big lift quantitative easing gave to risk assets. “It might not be totally symmetrical, but there will be a meaningful impact.”

The Barron’s article ends with this: “… investors should brace for added volatility. The Fed is entering the unknown, and so are markets.”

Some final thoughts

We have just ended a very strange month for the Treasury and TIPS markets, with uncertainty driving yields higher, lower, higher, lower — almost at random. Much of this volatility followed statements from Jerome Powell, chair of the Federal Reserve, and actions by the European Central Bank. While those statements seemed hawkish to me, the markets reacted with talk that the Fed would soon ease off and begin cutting interest rates again next year.

In his July 27 news conference, Powell said: “We are continuing the process of significantly reducing the size of our balance sheet.” But as the data show, that process has started slowly and has been an insignificant factor, so far, in bond markets. The 10-year Treasury note had a yield of 0.54% on July 1 and closed at 0.37% on Aug. 5.

This isn’t the way it was supposed to work, which forced San Francisco Fed President Mary Daly to step in Tuesday to declare that there is still “a long way to go” to bring inflation down from four-decade highs.

It seems clear to me that if the Fed ever wants to institute quantitative easing again in the future (and you know it will) it has to first drastically reduce its balance sheet, probably down to at least the September 2019 level of $3.8 trillion. That will take a lot of quantitative tightening, over a period of two years, or more.

Unfortunately, that sort of sustained tightening is not likely. And so … inflation will continue to be a problem. And inflation protection continues to make sense as part of your asset allocation.

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Feel free to post comments or questions below. If it is your first-ever comment, it will have to wait for moderation. After that, your comments will automatically appear.

David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can be purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.

Posted in Federal Reserve, Inflation | 25 Comments

A Greek-Italian restaurant can tell you a lot about real world inflation

Posted on August 2, 2022 by Tipswatch

By David Enna, Tipswatch.com

Editor’s note: This is an updated version of an article I first wrote in 2017 and revised in 2021.

There’s a restaurant in my hometown – Charlotte, N.C. – that has been in business continuously at the same location on West Morehead Street since 1952. The restaurant business draws a notoriously fickle clientele, so that’s pretty remarkable.

The Open Kitchen was founded by Steve Kokenes, who was Greek, not Italian. His menu of pizza, lasagna, spaghetti and other “international” cuisine was a rarity for Charlotte in those days. The city didn’t get an authentic Italian restaurant – meaning, run by actual Italians – until the late 1980s. But that didn’t matter; the Open Kitchen specialized in simple, tasty comfort food and it prospered.

The restaurant expanded in the 1960s and 1970s. An interesting side note is that its location — once a dreary area of warehouses and factories — is now a booming area of modern apartments, art galleries, trendy breweries and “artisan” restaurants, very close to Bank of America Stadium. It’s now a very valuable piece of property. But the Open Kitchen is still there, still consistently serving “comfort food” to a loyal clientele.

The restaurant is still run by members of the Kokenes family, who wait tables and run the cash register. And they have a remarkable collection of Charlotte memorabilia displayed all over the walls. But what really caught my attention on a past visit was a 1963 menu posted by the entrance to the dining room. It’s especially interesting since today’s menu contains many of the same items – with exactly the same names – 59 years later. Aha! This offers a unique look into inflation over the last 59 years, and … what could be in store for our future.

Full 2022 menu is here.

Where were you 59 years ago?

Back in 1963, $1 was worth … well, one dollar. And that is still true today. But adjusted for inflation (based on the Bureau of Labor Statistics’ Inflation Calculator) it takes $9.68 in today’s dollars (up from $8.89 last year, which is depressing) to equal the buying power of $1 in July 1963. That is an increase of 868%, and it is my baseline for comparisons of price changes from 1963 to today.

Anyone who drove a car before the 1973 gas crisis fondly remembers gasoline at 25 cents a gallon. That’s what it was selling for back in 1963. But in reality, gas prices until a couple years ago were as cheap (relatively speaking) as they were in 1963. However, even after dipping a bit this month, gas prices have almost doubled in the last five years and the cost of gasoline has now surged 1,584% since 1963, much higher than the rate of overall inflation.

And look at the median U.S. home sales price – $402,400 in 2022 – up 22% over the last year and 2,136% since 1963. Home prices have been running well above inflation. Same with the stock market, which has endured four bear markets in the last 22 years and yet is up 4,983% since 1963, nearly six times inflation.

At the same time, the U.S. minimum wage at $7.25 has lagged well behind inflation. At this point, I think, the minimum wage is an archaic idea that should be set to a realistic number ($15 an hour? $18?) and indexed to inflation, or simply abandoned.

The Open Kitchen: Then, and now

I included the Bureau of Labor Statistic’s Food Away From Home index in the chart, which should give you a realistic idea of restaurant price increases over the years. That index was up 7.7% in the last year and 1,105% over the last 59 years.

But the Open Kitchen is an interesting case study. When I did an update to this story last year, many of its prices were still very close to or the same as their 2017 levels. But in 2022, its typical prices have increased at a rate of 11% to 15%, more than the overall restaurant industry. That is realistic since it held prices close to stable from 2017 to 2021.

For example, Spaghetti with Meat Balls and Mushrooms (one of my favorite Open Kitchen offerings) costs $17.25 today versus $1.50 in 1963, a 1,050% increase that is very close to the overall Food At Home index increase of 1,105%. But the price popped up 30% in the last year, bringing it to a more realistic level, I assume.

There are a few bargains on the list: An extra meatball, for example, costs $2.25 today, same as last year, and 800% more than the 1963 cost of 25 cents. That 800% increase is lower than overall U.S. inflation and the Food at Home index. (Waiter: Extra meatball, please!)

Want the more exotic Ravioli Parmigiana? That will cost you 1,140% more than it did in 1963, and probably destroy any hope you had of maintaining your diet. Want half spaghetti, half ravioli? (Good choice.) That will cost you $11.25 and I’d say that’s a bargain, but the price is 1,025% higher than the 1963 cost. So, dang, not really a bargain.

One clear bargain is Spaghetti with Chicken Livers, which now goes for $14.75, versus a rather pricey $1.75 in 1963. That’s an increase of 743%, well below the rate of overall inflation. (This dish is now relegated to very fine print at the bottom of the current menu. Understandable.)

The Open Kitchen also offers a new dish, “Chicken Livers Greque,” with this awesome description:

Plump, juicy chicken livers sauteed in butter, delicately seasoned with oregano and lemon. Served with garden salad and French fries. ($15.50 … <up from $13.50 a year ago>)

I imagine that The Open Kitchen doesn’t sell a lot of Spaghetti with Chicken Livers or Chicken Livers Greque, but it’s a testament to their sense of tradition that they keep these on the menu.

A real world example, in our lifetimes

If you were alive in 1963 — I was 10 years old then — you and I have seen U.S. inflation rise 868% in the last 59 years. Gasoline costs are up more than 1,500%. A typical American home now goes for $402,000 versus $18,000 in 1963.

Inflation is an unrelenting force. I look at today’s Open Kitchen prices and my reaction is “perfectly reasonable.” But imagine if you saw these prices in 1968. You’d have been stunned. Now, imagine the prices you could be seeing in 20, 30, 40 years.

Inflation is dangerous. It’s a force that must be considered.

Another real world example

This week I received my natural gas bill for July. The cost was $91.97, which was 22.6% higher than the July 2021 bill. A year ago, in July 2021, we used more therms (49 vs. 46) and the bill was for more days (34 vs. 32), and even with that … the 2022 bill was 22.6% higher.

This is inflation. I can pay this bill. But a lot of people can’t handle a 22% increase in a basic cost of life.

Note: If you know young people who fail to understand and fear the force of inflation, please share this article with them. This all happened in our lifetimes. It will continue throughout their lifetimes.

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Feel free to post comments or questions below. If it is your first-ever comment, it will have to wait for moderation. After that, your comments will automatically appear.

David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can be purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.

Posted in Inflation | 17 Comments

Confused by TIPS prices? Here’s a walk-through.

Posted on July 24, 2022 by Tipswatch

Yes, you can make sense of the complex pricing of Treasury Inflation-Protected Securities.

By David Enna, Tipswatch.com

Last week, I decided to buy $15,000 of the new 10-year Treasury Inflation-Protected Security — CUSIP 91282CEZ0 — being offered at auction by the U.S. Treasury. I was making this purchase in a Vanguard brokerage account (a traditional IRA), where I had set aside $15,095 in cash for the purchase.

The problem was: Would that $15,095 cover the cost, after any premium/discount to par value, plus any additional accrued principal and interest? The Treasury’s official announcement for the auction wasn’t much help, with all the important pricing details to be “Determined at Auction”:

So I did a quick calculation:

  1. I was buying $15,000 of par value.
  2. I knew the real yield to maturity would be at least 0.50%, because that was where the 10-year TIPS market was trading. That would mean the real yield would NOT be below the coupon rate, which only happens when the real yield is less than 0.125%.
  3. Therefore, this TIPS would be sold with at least a slight discount to par.
  4. But … this TIPS would have an inflation index of 1.00495 on the settlement date of July 29, so that would add to my purchased principal, and the cost, along with a small interest adjustment for 14 days of the coupon payment (from the July 15 issue date to the July 29 settlement date).
  5. So, I figured, the highest cost I would end up paying wound be about $15,000 x 1.00495 = $15,074. And I concluded that my $15,095 would cover the cost.

Let’s see what happened

The auction ended up producing a real yield to maturity of 0.630%, which then caused the Treasury to set the coupon rate at 0.625%. When a TIPS has a real yield of 0.125% or higher, the Treasury always sets the coupon rate to the 1/8% below the real yield … 0.125%, 0.250%, 0.375%, o.500%, 0.625% … and so on. A real yield of 0.630% gets a coupon rate of 0.625%, and the price is set at a very small discount to par. A real yield of 0.620% gets a coupon rate of 0.500%, and the price gets a bigger discount.

Here are the auction results, as reported by the Treasury in its official announcement:

So, what does this all mean — high yield, adjusted price, unadjusted price, adjusted accrued interest, index ratio — and how does it affect the price I paid?

The high yield becomes the TIPS’ official real yield to maturity in the auction records. It is the highest yield the Treasury had to grant to complete the $17 billion offering of this TIPS, and it is the real yield granted to all non-competitive bidders (that’s pretty much anyone putting in a purchase order at TreasuryDirect or through a brokerage).

After the auction was completed, Vanguard reported my cost for $15,000 of par value to be $15,070.55. What factors went into setting that price? Once the high yield was set, all the other pricing fell into place Let’s take a look:

Click on the image for a larger version.

The key factor in this chart is the unadjusted price, which was $99.9517 for $100 of par value, and that meant my core cost for the $15,000 in par value was $14,992.75.

But, because of the inflation index of 1.00495, I will be purchasing 14 days of inflation-adjusted additional principal on the settlement date of July 29. That raises my cost to $15,066.97.

In addition, I will have to pay for the 14 days of coupon rate interest that will have accumulated by July 29. Since the coupon rate is 0.625%, 14 days of interest would be about 0.0239%. That is why the adjusted accrued interest is set at $0.239 per $1,000 of par value. Since my accumulated principal will equal about $15,066.87 on July 29, my accrued interest is about $3.60.

And that sets the total cost of the investment: Inflation adjusted value + accrued interest. $15,066.87 + $3.60 = $15,070.57. (OK, Vanguard said it was 2 cents less. I’ll take it. Savings!)

The last line on that chart shows the total value of the investment on July 29, which is simply par value ($15,000) x the inflation index (1.00495) = $15,077.85. In this calculation, I am ignoring the coupon interest which will be paid out as current income twice a year. Also, don’t confuse “total value” with “market value.” Total value reflects only par value + inflation accruals. Market value adds in the fact that the price of a TIPS changes daily on the secondary market. If you are holding to maturity, you can more or less ignore market value.

Happy side note: The inflation index for this TIPS on Aug. 31 will be 1.01939, up 1.3% for the month because of the high rate of non-seasonally adjusted inflation in June. That will put its total value at $15,290.85. Not bad.

Conclusion

I hope this primer on TIPS pricing is helpful. The July 21 auction was an easy one because the real yield ended up just a hair above the coupon rate, making the unadjusted price very close to par. In the last two years that hasn’t be true, with negative real yields far below the lowest possible coupon rate of 0.125%. I am hoping we are entering a new era of positive real yields and much more sensible TIPS pricing.

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David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can be purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.

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