Lone Wolf wrote:
So there you'd be, stuck with an instrument that with these yields will slightly lag the CPI (which I think will tend to somewhat understate inflation for the "man on the street".) And there it is, sucking up all your tax-deferred space, mocking you. And I can't even imagine these poor things trying to carry the other floundering 75% of the portfolio. I mean, am I overselling the problems here? It seems pretty bad to me.
I agree with Lone Wolf.
Another issue with using TIPS to substitute for gold has to do with how inflation is defined and how the CPI is calculated. The CPI (Consumer Price Index) is used as a stand-in for inflation, but it is not the same as inflation. But that's a discussion for another thread.
Back in the early 1990s there was a radical change in methodology for calculating the CPI, in response to the budget deficit, among other things. Basically, the CPI went from being a measure of price changes in a fixed basket of consumer goods, to being a measure of price SUBSTITUTIONS in an ever changing basket of consumer goods. Under the original calculation, if the price of beef went up, this was reflected directly in the CPI. Under the current calculation, if the price of beef goes up, the algorithm that calculates the CPI has built into it an assumption that rational consumers would substitute chicken, fish, or some other cheaper meat for beef. The algorithm continues this substitution ad infinitum. If a three-bedroom home is too expensive, the consumer moves into a two bedroom home; if new cars are expensive the consumer buys used; if the price of gas goes up, consumers ride the bus. The immediate effect of this change was that the index went down substantially, so much so that in some years it seems to indicate that there is no inflation at all.
Which brings us to the other effect: The new CPI does not match everyday experience for lots of consumers (Lone Wolf's "man on the street"), especially those on fixed incomes or those having to deal with mandatory wage freezes at work. It's hard to believe that the CPI is running along at a mere 1.2% when the price of Froot Loops has gone from about $3.50 a box to $4.99. (Or even worse, when the 1 ounce, 25 cents bag of Cheetos has been transformed into a 0.75 ounce, 33 cents bag--along with a proliferation of bag sizes and differential prices on the same bag size to keep the consumer confused.)
Several economists have been calculating the "old" CPI to keep up with "real" inflation. You can find an example at Shadowstats.com, which is run by the economist Walter J. Williams. He has several free articles on his site; in one of them he points out that if the methodology for calculating the CPI had remained the same since the early 1990s, then employees, retirees, and others with COLA clauses in their contracts (or a COLA in the law that governs their benefits, like the amended Social Security Act) would be paid twice as much today as they are actually receiving. (BTW, The average Social Security check as of September 2010 is $1072.20 per month, according to the Social Security Administration's figures. The maximum for a retired individual is $2,346 per month. Imagine if those figures were doubled. Social Security would have been wiped out by now. Williams says this is the real reason for changing the CPI calculations.)
Using the CPI to introduce a cost-of-living adjustment in government programs became law in 1972. There have been minor adjustments throughout the years, but the substantial changes in methodology for calculating the CPI came in the early 1990s, long before TIPS were first sold in 1997.
I am not saying that TIPS are useless, or that they should be avoided for anyone's portfolio. A bit of inflation protection in a bond simply adds diversity to the bond options out there. It might be better than none at all.
My point is that if we were to encounter any serious (double digit) future inflation, I would not be surprised if the methodology for calculating the CPI were to change again. Not just to keep TIPS interest rates in check, but to keep all programs in check that have COLAs based on the CPI.
If there were hyperinflation of 50%, I do not believe that the yields on outstanding TIPS would be allowed to ratchet high enough to protect a portfolio relying on them for inflation protection. In that case, the Treasury Department might call all TIPS, pay off the principal and any accrued interest in nearly worthless dollars, and cancel the product. (But who really knows what Treasury would do?)
But if you had gold in your PP, you would not have to worry about this. Its price in dollars is likely to skyrocket in that case, protect the entire PP from collapse, and save your assets.
Sorry for the politics. As someone else said, it's hard to explain concepts in the HB PP without an occasional resort to political economics.