Inflation Expectations Revisited

In this How To Calculate Expected Inflation post from April 2011, I described the process of finding the rate of inflation expected by investors.  At that time, the rate for the 10-year period examined was 2.65%.  This was based on a yield on the 10-year Treasury note of 3.52% and a rate on the 10-year TIP of  0.87%.

Well, yields have changed since then.  Today, going to Bloomberg, etc. as described in the previous post shows that the yield on the 10-year Treasury note is 1.83% and the yield on the 10-year TIP is -.74%. S ubtracting, gives us an inflation expectation of 2.57%.

I have to say that I am surprised that the expectation has dropped slightly, in light of the ongoing printing of money and monetizing the Debt; but I understand there are factors influencing inflation other than money and that a lot of what we have seen is a build-up of excess reserves which still, this late in the recovery, have yet to be lent. 

This inflation expectations number is important to follow because it impacts views on what the Fed can and cannot do, the budget, and yield premiums on longer-term fixed income instruments.

It is, however, in my view, a very narrow reflection of inflation.  In fact, I will go out on a limb and argue that most economists don't really understand inflation.  To many, inflation is measured by the cost of a basket of goods and services over a period of time.  Others take a somewhat broader view and take a measure based on GDP--called the GDP deflator--or focus on Bernanke's favorite--the PCE deflator--reported with Personal Income.

All of these measures, I believe, miss the totality of inflation.  To me, inflation has to itself be put in real terms - specifically into labor units.  If the average labor force participant has to work more hours today than a year ago for a basket of goods, then we have inflation.

Think about this in light of what was reported above from the perspective of the tidal wave of retiring baby boomers.  In April 2011, a retiree who put $1,000 worth of stored up labor (40 hours, say) into a 10-year U.S. Treasury note got to buy $35.20 worth of goods and services.  Today the same $1,000, i.e. 40 hours, based on the 1.83% yield on the Treasury note, can buy $18.30 worth of the basket!  He or she would have to give up approximately twice the number of stored-up labor hours to get the same goods and services!  This is an inflation that is missed and is part of what is killing the economy IMHO. In fact, from a retiree's perspective, looking at money market and CD rates, it borders on hyperinflation!

So, Helicopter Ben continues to write checks out of thin air and baby boomers continue to take on riskier and riskier assets and Helicopter Ben puffs up and proclaims that one mandate - stable inflation - is being met.  What he doesn't get is that when you control prices, i.e. the price of money via the fed funds rate you are going to get inflation in some form.  Right now, it is a form that beats up on retirees and those trying to save for retirement.

I believe his price control policies are wrong and, like 2001 and 2008, in the end we may end up once again walking around like zombies wondering why the economy isn't working -  muttering about bubbles.How to Calculate Expected Inflation

Are You Leaving $100 Bills on the Table?

Imagine getting out of your car at the supermarket and finding ten $100 bills lying on the ground.  What would you do?  My bet is you would do a "Chauncey." (See the video)




Well, there are a lot of people leaving $100 bills behind - a lot of $100 bills.  I know because I look at their statements.  This is especially on my mind now because I recently sat down with a lady in her mid-40s who had a bit more than $150,000 in various savings accounts and another $100,000 in certificates of deposit (CDs).  The savings account paid less than 0.5% and the CD rates were between 1% and 1.25%.

Me:  "You have a lot invested in cash equivalents."
Her:  "In case of emergency."
Whoa...she's braced for a heck of an emergency.

Like most advisors, an emergency fund is one of the first things I talk about and make sure a client has in place - they are tricky.  They depend on the stability of the client's income, type of car and age of house, etc.  Basically you want to be able to pay your Discover bill at the end of the month after having to buy a new water heater.  Assuming your job is stable, a couple of months' salary is sufficient.

As you have guessed,  having too big of an emergency fund leaves $100 bills on the table.  This jumps out at anyone who is aware of yields available in the market place.  If you have $50,000 more in emergency funds than you need and can increase the return on these funds by 2%/year, it amounts to $1,000/year.  Where's Chauncey?

Do the math for the lady in the example who has $250,000 in cash equivalents!  Because she is in her mid-40s, she has approximately 20 years until she is 65 years old and  will compound the money over the period.  She is leaving a lot of $100 bills on the table!

On occasion, the dialogue has gone like this:
Me:  "You have a lot invested in cash equivalents". 
Her/Him:  "Stocks and bonds are risky."
Let's talk about risk.

Stocks and bonds do go up and down, and that can be truly exhilarating or lead to grinding your teeth in your sleep depending on the extent to which you watch it and let it affect your emotions.  That's the risk most people focus on.  But there is also inflation risk that is more subtle.  For example, it seems like yesterday when people would tell me that they could invest in U.S. Treasury notes and generate $40,000/year.  Why did they need stocks or higher yielding, more risky, fixed income exposure?  Fast forward to today, and $40,000 is equivalent to $20,000 and their 10-year Treasury note re-investments yield 1.6%!

Yesterday the 12-month Consumer Price Index was reported at 1.7%.  Investing cash equivalents at less than 0.5% or even in CDs at 1.5% is losing ground to inflation!  The bottom line is that risk comes from many directions, and hiding in cash equivalents leaves a  lot on the table.  It pays to investigate low risk ways of increasing yield on emergency funds and other short term investments..

Disclosure:  The purpose of this post is educational.  Individuals should consult with a professional or do their own research before making investment decisions.