Updated February 2021

INFLATION PROTECTION

Abstract:  Inflation and deflation are rooted in fluctuations in money supply, interest rates and economic growth.  Over the last 30 years government statistical agencies have modified their methodology for calculating inflation frequently with almost all changes serving to reduce, sometimes dramatically, the official US reported inflation rate and supposedly make it more accurate.  Equities and fixed income tend to do better when inflation is low or declining or when deflation is occurring.  Rising inflation and its counterpart, rising interest rates, adversely affect borrowing and leverage.  When interest rates are high borrowing is expensive and heavily levered assets like stocks, bonds and real estate tend to underperform.  Gold and commodities have uncorrelated returns with equities and gold is the only asset class with a positive correlation with inflation.  Inflation protected securities do not have a good historical track record in protecting investors from inflation and have shown little correlation with inflation.

DEFINING DEFLATION AND INFLATION: Deflation is defined by Webster's Collegiate Dictionary as a contraction in the volume of available money or credit that results in a general decline in prices.  Inflation is defined as a continuing rise in the general price level, usually attributed to an increase in the volume of money and credit relative to available goods and services.  Inflation can occur in investment assets like stocks, bonds or real estate and/or in the cost of living and consuming as measured by the CPI, the consumer price index for goods and services.  As the stock, bond, and real estate bubbles since 1996 have shown, when assets rise in price faster than economic growth it is generally not considered a problem unless a large percentage decline occurs like early 2000 in stocks and 2007 in real estate and 2008 in stocks and bonds and early 2020 in equities.

It is important to note that economic contraction is often erroneously referred to by the press and financial industry as deflation instead of recession.  Economic contraction does not necessarily lead to deflation and inflation can climb while economic contraction occurs.  This is called "stagflation".  Two significant US recessions occurred between 1968 and 1980 as inflation climbed from around 3% up to 11%.  The Federal Reserve's official position as of 2019 is that inflation needs to be kept around 2% or a little higher to compensate for times when it was lower than 2%.  Why this percentage was chosen is a mystery.  Academic research does not confirm that there is any optimal inflation rate or whether any inflation at all is healthy for economies long term.  The Fed apparently knows better than academic Ph.D.'s.

WHAT CAUSES INFLATION:  An oft-quoted statement from Milton Friedman and Anna Schwartz, two of the most eminent economists of last century, pretty much describes it, "inflation is always and everywhere a monetary phenomenon."  When money supply, the monetary base, and debt expand at rates exceeding that of a country's GDP growth rate, then inflation will eventually result because more units of money are chasing a slower output GDP output of goods and services.  In other words, the creation of currency and debt in excess of true economic growth creates inflation.  As of early 2021 US money supply has been growing at over 10x US GDP growth and this is otherwise known as currency debasement.  The velocity of money, whether it is spent fast and passes quickly or slowly from one individual to another, also drives prices but it is difficult to quantify and varies about a wide unpredictable mean based on inflation expectations and emotions, the desire to save and other factors.

Demand for a given good or service is often erroneously presented as the cause of a rise in prices but this is never the root cause of overall long-term inflation.  The root cause is excessive currency expansion.  If, for example, the supply of money and credit in a given economic system were to precisely match the growth rate of the economy, a rising demand for oil or decline in the supply of oil might drive up prices for oil but money or credit would have to be taken from elsewhere in the economy, say automobiles or health care, and the overall aggregate price level would stay about the same.  Keynes suggested that money and credit should be expanded at around 2% per year to account for economic and population growth although that percentage is pretty much plucked out of thin air and is similar to today's Fed inflation target as of 2020.  Keyne's also advocated increasing the money supply when the economy needed stimulation and then paying back the debt after the economy recovered.  That doesn't seem to be happening in the last 3 decades or so.  Keynes, however, lived in a time when currency and debt were backed by gold.  Once the US went fully off the gold standard in 1971 the supply of money and credit has risen more or less continuously at a rate far exceeding GDP growth since the mid-1980's.  Inflation can also occur when workers strike and demand more compensation because their cost of living is increasing.

MEASURING INFLATION:  The Bureau of Labor Statistics (BLS), an official US government statistical agency, calculates and publishes inflation data monthly.  The methodology involved in the construction of these indexes influences the reported inflation rate.  There are several versions of the CPI put out but the two most often quoted numbers are the "core" CPI and the CPI-U (urban) index.  The core CPI index removes food and energy costs on the premise that their prices are too volatile.  The CPI-U includes them and tracks a wide variety of goods and services.

The CPI numbers produced by the BLS underlie many other government statistical calculations.  The GDP is adjusted by the CPI to determine inflation adjusted economic growth.  Government and financial industry predictions of GDP growth are invariably too optimistic and downward revisions in the numbers are frequent after the headline numbers have been released at an earlier time.  For example, in May 2019 US GDP growth estimates were reduced downward from over 3% to a much lower 1% to 1.4% in the prior three months.  Weak economic numbers can cast doubt on the economy and present problems for the Federal Reserve and US government and for politicians crediting themselves with having created economic growth.  Productivity gains, GDP output divided by hours worked, income growth, consumer spending, and other key economic statistics are heavily influenced by inflation adjustments.  The lower the inflation adjustment the better the economy looks.  This is particularly critical for Social Security and various welfare programs, government salaries, and government budget plans.  Expected high inflation makes them more expensive to fund.

HOW TRUSTWORTHY IS THE CPI?  For over two decades the BLS has repeatedly revised their methodology for the creation of the monthly CPI number.  Virtually all modifications have resulted in lower inflation rates.  The CPI has reduced reported inflation in three ways.  It has been reduced by the omission of housing prices since 1984, a big factor, even though housing prices have risen 500% or more in most parts of the country since then.  Instead, "owners equivalent rent" was inserted in the CPI to capture housing costs and rents rose far more slowly than housing prices up until around 2012.  To determine owners equivalent rent a few thousand home owners are interviewed and asked what they think their homes would rent for.  There is no attempt made to determine if their estimates reflect what real world rental prices might be for comparable homes.  Another government statistic, the GDP, is boosted strongly by these rental estimates in that the hypothetical total rent all US homeowners could get for their homes is added on to the GDP every year.  As of 2019, this hypothetical rent added about $1.4 trillion to the GDP.   However, homeowners live in their homes so they couldn't rent them.

Today, the majority of the items in the CPI are "hedonically" adjusted; e.g. car prices aren't included in the index at the price a real buyer would pay for a real car.  Instead, since autos are continually getting better their dollar price is adjusted downward in government data even though the real cost of buying a car is moving upwards.  Auto prices were entered into the CPI inflation rate at about half their dealership price as of 2019.  This is done since autos are deemed "hedonically" better then they were in the past and therefore cheaper.  But, today's auto buyers actually pay far more dollars for a car rather than fewer.  Another downwared adjustment the BLS performs on the CPI number assumes consumers will substitute alternatives if their favored consumption product rises too much in price.  The majority of items in the CPI index are adjusted downwards through "chain weighted linking".  The idea here, described on the BLS website, is that if the price of beef goes up then chicken will be substituted in the index on the assumption that consumers will eat more chicken and reduce their food costs.  A CPI index should, in the opinion of most statisticians, not be subject to continous change in calculation methodologies otherwise inflation statistics from the past aren't comparable to inflation numbers today.

Whatever the real consumer rate of inflation might be, it is obvious that US inflation data isn't something which is comparable over time, the CPI is not a stable benchmark, and the CPI is subject to many adjustments designed to lower it.  The idea behind the index was to provide a measure of what it takes to enjoy a constant standard of living.  In January 2010, Michael Boskin, who along with Allen Greenspan in 1997 argued for and got the CPI reduced by about 1%, recanted a bit and published an opinion piece in the Wall Street Journal about growing deception in government statistics, the understatement of inflation in the CPI, and optimistic distortions in government statistical reporting.  In June 2013 a former head of the BLS publically stated that in his opinion the current official CPI numbers very significantly understates inflation.  The US government is motivated to report low inflation for political and budgetary reasons.

HOW HIGH HAS INFLATION BEEN HISTORICALLY?  For 1926 through 2011 the official CPI-U inflation rate was close to 3% per year resulting in a compound reduction of US consumer purchasing power by about 95% in US dollars.  It is worth noting that the Federal Reserve's initial and continuing mandate has been to maintain stable prices.  It has failed miserably in that regard.  Historically, currency debasement and inflation have been the universal rule for all countries, even in ancient Greece and Rome which used gold and silver coins.  An IMF study in 2011 found that the average life span for a fiat currency mandated by the government had been 42 years in the post-WWII period.  The US dollar has been a fiat currency for over four decades since President Nixon severed the final link between the US dollar and gold in 1971.

We can also measure US inflation referenced to gold, a form of money which can't be debased.  In 1926 gold was officially priced at $25 an ounce.  In early 2021 it was trading around $1850 an ounce or roughly 75 times its price in 1926.  And, in early 2021 it is trading about 10% off it's all-time high of $2069/oz in 2020.  Based on gold, the dollar has lost about 98% of its purchasing power if measured in gold.  If gold is used as a measure of real returns for asset classes, equity and fixed returns in the 20th century look pretty meager.  From 1926 through 2009 the S&P 500 only gained about 25% priced in gold, not much for 84 years.  Priced in inflation adjusted CPI based dollars the S&P approximately doubled in that 84 year period.  From 1971 through its peak at over $1900 an ounce in 2011, about the same as that of the S&P 500 stock index with dividends reinvested, both gold and the S&P rose about 50 times in price if not adjusted for inflation.  Prior to 1971 gold's price had been fixed by the US government since the 1800's and a comparison with other investments isn't meaningful since the price rarely changed.  In true purchasing power as measured by a depreciating dollar value in gold, stock returns have not been all that spectacular over the last century. "Real" inflation adjusted market returns with inflation defined as a rise in the price of gold are far lower than the "nominal" returns Wall Street and the financial press frequently quote.

EQUITIES AND INFLATION:  Equities are often promoted by Wall Street as protection against inflation and if held over several decades that is true.  Dimson et. al. ("Triumph of the Optimists") was published in 2003 then updated from 2009 through 2018 in the "Credit Suiss Investment Returns Yearbook", available online for free.  Dimson et al's research covers 119 years for 25 countries since 1900.  His group estimates an inflation adjusted equity premium above fixed income of 3.5% for a globally diversified equity portfolio with a small/value tilt.  Fama and French of DFA estimate similar premiums.  The financial industry frequently mentions a long term equity return in a well-diversified equity portfolio of about 5% after inflation.

Equities tend to do well during periods of declining inflation, low inflation, and even during deflation.  From 1982 through 2000, a period where inflation and interest rates more or less continuously declined, the US enjoyed its biggest bull equity market in US history.  From 1968 through 1982, equities did poorly, declining about 50% and only managing to break a little above even in inflation adjusted terms after 14 years.  Interest rates rose the the mid-teens during that period.  Bonds also did very poorly due to rising interest rates.  During periods of rising inflation, consumer and corporate borrowing costs increase, mortgage interest rates increase, and consumers and businesses have less money to spend on growth, investment, homes, and consumer durable and non-durable goods and services.  Cycles of rising inflation and interest rates and declining inflation and interest rates have occurred in roughly 10 to 20 year intervals for the last 100 years though increases and decreases are not smooth, are unlikely to be profitably timed, and are continuous.

FIXED INCOME AND INFLATION:  During periods of inflation lenders and investors demand higher interest rates from debt.  They want to avoid being hurt by a decline in the inflation adjusted purchasing power of the interest they are paid and so bond prices decline and interest rates rise.  Bonds purchased when interest rates are low or extremely low decline in value when rates rise.  That was the case in 2019. The longer the maturity of the bonds the more they decline in price if interest rates are rising.  A rough rule of thumb is that an increase of 1% in market interest rates for a given quality and maturity bond will cause a decline in the value of previously purchased bonds of similar maturity approximately equal to their maturity or, for a bond portfolio, the duration of the portfolio.  For example, a mutual fund with a duration of 5 years could be expected to decline about 5% if  tomorrow morning interest rates suddenly rose 1% on 5 year bonds or 10% if interest rates rose 2%.  These shifts in bond value and share price value in bond mutual funds are not linear.  As of 2019 interest rates were very low compared to historically average returns with the overnight money rate at 2.25% to 2.5% compared to a long term average overnight rate around 6%.

Dimson et al. compared bond returns for 19 countries for 112 years, 1900 through 2011, a total of 2,128 country-year observations.  When inflation was in the bottom 5%, strong deflation, equities gave a real annual return of 11.2%, high, but dramatically underperformed bonds at +20.2% annually.  When inflation was in the top 5%, strong inflation, equities lost 12.0% annually but bonds did much worse, declining 23.2%.  Over the entire period, bonds gave a geometric real return of 1.7% compared to 5.4% in stocks with the standard deviation of bonds at 10.4% well below stocks at 17.7%.

Long maturity bonds are particularly treacherous and this is why DFA, EAM and most advisors recommend only short or intermediate maturity ranges, 1-8 years or so to maturity.  If one purchased a 30 year Treasury in 1941 one would not have broken even until 1991 after inflation.  But, as an illustration that even relatively long-term asset class returns constantly alternate, if one purchased 30 year Treasuries in 1981 when interest rates were in the high teens, their return was about the same as the S&P 500 with dividends reinvested for 1981 through 2011, a 31 year period, even though that period includes the biggest bull market for stocks in US history.  In the US as of early 2021, short interest rates are zero or close to it after inflation, longer rates are near all-time record lows, borrowing and debt by the Federal government are rising rapidly, aggregate money supply growth is rapid and at record levels, and the next interest rate cycle is certainly upwards.  We can't, however, know when it will begin, how much rates will rise, and when rates will head down again.  Bond market prices as of early definitely do not bode well for future returns in fixed income.  It is important to note that although the Fed can dictate interest rates in shorter maturity debt to some degree at several times in the past it has completely lost control of interest rates.

REAL ESTATE AND INFLATION:  Real estate is usually purchased with borrowed money, leverage, and in times of declining or low interest rates and cheap money, tends to do very well.  Rising mortgage interest rates hurt real estate returns.  As of early 2021, 30 year fixed US mortgage interest rates were very low and close to the inflation ratelow, around 3.0%% and roughly 3% below long-term historically average mortgage rates.  Robert Shiller of Yale has collected housing price data going back to the late 1800's and finds real inflation adjusted returns in housing for that period around 1%, fairly close to T-bills.  From 1987 through 2011 the Case-Shiller housing price index for 10 major cities produced a real return of 1.15% annually after inflation.  During the inflationary 1970's, US housing returned 1.02% per year after inflation.  Dimson et al. looked at real housing prices across six countries for which data were available from 1900 through 2011.  They found that, after controlling for country-specific factors, real housing appreciation was very weakly correlated with inflation at -.20.  They concluded that real housing prices seem relatively insensitive to inflation but have kept pace with it over the long run.  The real estate and housing industries, of course, like to present numbers showing 10% or higher price "appreciation" annually for a selected time frame though that might as well be considered inflation for anyone wishing to buy a first home.  As of 2021 many articles have been published in the financial press about the inability of younger adults under 40 to afford today's record and near-record home prices.  As of January 2021 US housing inventory was at a record low of only 1.9 months supply and suggests housing investors are "all in" on their bet.  In June 2020 supply would have covered about 4.5 months.

Commercial real estate has tended to return less in price gains than housing but it offers generally high rental income from cash flow versus most other investments.  REIT's, publically traded investment real estate in apartments, condos, shopping centers, hospitals, and other entities, have offered long-term total returns comparable to common stocks.  From February 1993 through April 2010, DFA's US REIT portfolio gave an annualized inflation adjusted return of 7.07%, about 1.5% above the S&P 500.  Investors should bear in mind, however, that REIT's can be highly volatile.  In the early 1970's, the NAREIT index dropped over 80% and for the inflationary 1972 through 1982 period, lost a breathtaking 17% per year.  Dimson et al analyzed commercial real estate returns using a limited portion of their data base and controlling for country specific factors.  They found a correlation between commercial property and inflation of -.33.  Dimson et al concludes "given its relative illiquidity, commercial real estate has to be considered as a long-term commitment...and is not an investment that should be initiated because of a new concern about inflation risk."

GOLD AND INFLATION:  Gold is a special case commodity in that it has been considered money and defined as the premier store of value and medium of exchange, for 5000 years.  An article elsewhere on our website, "Alternative Assets", discusses gold in more detail.  A WSJ article (8-21-10), "Rethinking Gold", reports research by Ibbotson indicating a 0.08% correlation between gold and inflation but a -0.65% correlation between gold and the US dollar since 1980.  From April  2020 through end 2020 the US dollar declined about 12% versus a basket of major foreign currencies.  The author suggests that gold is a currency, not a commodity, and massive US Treasury borrowing, the emergence of "currency wars" and record central bank money creation (The Economist, October 16-22, 2010) are strong drivers for eventual US dollar declines and a rise in the price of gold.

Gold possesses many desirable qualities.  Unlike paper and digital currencies, it is very difficult to debase and debasement is easily detected.  It is nobody's liability and rests on no counterparty's promise to pay.  About half of all gold above ground is held by central banks and is likely to remain that way and central banks hold gold bars, not national currencies.  Gold is not a consumable commodity like energy or agricultural products, gold is nearly indestructible, and its supply is relatively inelastic to demand.  Almost all the gold that has ever been mined is above ground.  Mining is expensive and energy intensive and even at full output the world gold supply can only be increased annually very slowly, if at all.  Paper and digital money can be increased at will at any time in any amount with no limits by government Treasuries and central banks.  Over the last decade, global gold mining costs have tripled while production has grown little.  Discoveries of new gold reserves are rare and Goldman and others as of 2015 estimated about 20 years of gold production left before gold production just about ceases unless major new reserves are discovered.

For millenia, the prices of commodities like horses and potatoes have stayed fairly constant when measured in gold's weight.  The longest lasting fiat paper currencies have all declined to relatively worthless in a little over 100 years.  Gold is a true measure of inflation and gains over time against fiat paper currency.  JP Morgan, the financial titan who bailed out the US banking system in 1907 and the richest man in the world at that time, stated, "Gold is money.  Everything else is paper."  Meyer Rothschild, probably the world's richest man in the 1800's, expressed similar sentiments.

Though used in technology, dentistry, jewelry and art, gold has limited intrinsic value as a commodity.  It's value is in its rarity and the costly process of mining and producing new supply.  If all the gold ever taken out of the earth were melted down and formed into a cube the edge of that cube would be about 80 feet and fit on the average lot of a suburban US tract home.  Estimated remaining global reserves are about a third of this.  Like original Van Gogh paintings, prime ocean view real estate, flawless investment grade diamonds, and Bugatti automobiles, gold's value is based on its rarity and its beauty.  Paper money, unlike gold, can be produced and debased at will by governments and central banks and they have always chosen to do so unless their currency is fully backed by gold.  Gold cannot be created at will and cannot be debased unless alchemy finally realizes its unlikely dream of changing lead into gold.

Over very long time frames gold tracks true inflation very closely.  For 1802 through 1997 gold returned 0.1% less than the inflation rate.  This is misleading, however, since from the 1870's up until 1971 gold's price was fixed by the US government.  For that 100 year period a total return figure understates gains in gold's value since its price couldn't rise unless it was reset versus the dollar since its price was fixed in US dollars.  It was reset a few times and approximately doubled in price over that period.  During the inflationary 1972 through 1982 period, gold returned 11.4% per year, over 10% annually above any other asset class.  Dimson et al. looked at gold returns in 19 countries for 112 years and found that when inflation was in the bottom 5%, strong deflation, gold returned 12.2%, a bit below bonds but well above equities.  When inflation was in the top 5%, strong inflation, gold gave a real return close to zero but far above all other asset classes.  This makes sense in that gold is the only asset that does not have its real value reduced by inflation.  Gold is an accurate measure of inflation over very long time frames.  Dimson et al. reported that gold was the only asset class with a positive correlation to inflation, +.26.  Equities correlated at -.52, bonds at -.74, bills at -.62, commercial real estate at -.33, and housing at -.20.

Ibbotson Research (Idzorek, CFA, 2005) looked at the benefits of including gold bullion in fully diversified equity and fixed portfolios covering 1971 through 2004.  They recommended that 7% to 15% of an investor's portfolio be allocated to gold bullion.  EAM typically recommends 5% to 10%.  For 2000 through 2009 gold returned over 350%, despite low reported inflation within the US, soundly trouncing a 0% return for the Dow Jones Industrials.  Most US investors are not familiar with gold although Asia and Europe have long understood its value and are big purchasers of gold.

Wall Street, academia, and the mainstream financial press are generally indifferent or critical of gold and either don't mention gold or discourage its ownership and allocation in investment portfolios.  The likely reason for this is that the financial industry doesn't make much money from gold and can't M&A it, IPO it, charge high management fees for it or derive much revenue from promoting it.  Investors are constantly warned of a possible gold bubble and often lectured on the lack of intrinsic value in gold or its lower long-term return versus equities or the 20 year gold bear market from 1980 through 2001.  Critics argue that it is a lump of metal and doesn't produce interest, dividends, or profit growth, thus its value must be subjective and only what investors accord to it.  The problem with these arguments is that "fiat" government paper and digital currency, and stocks and bonds priced in fiat currency or real estate purchased in borrowed fiat dollars, are only worth what investors accord to them if they are not linked to something of value that can't be created at will by central banks and governments...like gold.  And, 20 year or longer bear markets have occurred in stocks, bonds, and real estate, not just gold.

COMMODITIES AND INFLATION:  Commodities like oil and natural gas, base metals like copper, and agricultural products are tied to and constitute inflation and, like gold, their returns are uncorrelated with equities and fixed income.  For 1972 through 1998 the Goldman Sachs commodities index, GSCI, returned 10.3% per year, about 5% per year above the rate of inflation.  Investors wishing to capture rising commodity prices are faced with a challenge.  Commodity prices in US dollars are set in the US Comex futures market and these prices can disconnect completely from real commodities prices determined by supply and demand due to constant speculation in commodity markets.  Commodity index investments available to investors are usually based on levered commodity futures contracts, not cash prices, and futures prices can move far above and below cash prices and create rapid gyrations in prices.  The 2008 oil price bubble was driven by futures contracts, pushing oil from the $60/barrel range up to $150/bbl in a short period of time, then crashing oil down to $35, all in less than a year.  Leah Goodman's book, "The Asylum", examines the history, characters, and corruption of commodities exchanges with a particular focus on oil prices in 2008.  Another excellent book about manipulations in commodities markets is Charles Geisst's, "Wheels of Fortune".  In March 2012 the United Nations Conference on Trade and Development released an extensive and detailed analysis of the US commodity futures market.  They presented data indicating that high frequency trading computers (HFT) have caused US commodity futures prices to disconnect from real world supply and demand fundamentals since 2008.  In Q213 US gold prices dropped 22.8% from massive short selling in the Comex futures market while global demand for real gold was at record levels both before and during the periods where short futures contracts suppressed gold prices.

Capturing futures returns isn't a precise business in another way.  If we compare returns in 2011 for DFA's commodity index tracker, DCMSX, and Pimco's commodities fund, PCRIX, we find somewhat different results.  Both funds aim to track the same commodities index, the Dow/UBS index.  DFA uses a different futures contract roll strategy than Pimco's roll strategy.  DFA returned -12% in 2011 to Pimco's -29%, a substantial difference.  Pimco, however, managed to reduce this by 15% or so due to holding inflation protected securities which it added to its commodity fund in 2011.  Such a wide disparity for one year suggests that investors cannot be certain to capture real spot/cash commodity returns in funds using commodity futures contracts delevered by bonds.

INFLATION PROTECTED TREASURY ISSUES AND INFLATION:  In the late 1990's the US government introduced two types of bonds designed to protect investors from inflation, I-bond savings bonds and TIPS, Treasury Inflation Protected Securities.  I-bonds are purchased at face value and increase in value monthly.  Interest is paid when the bond is redeemed.  They may be redeemed at any time after a twelve-month holding period and grow in value with inflation-indexed earnings for up to 30 years.  I-bond returns result from a combination of the long-term fixed rate and an inflation rate adjustment to price every six months.  The adjustment is based upon the CPI index and added on to the value of the bonds.  If there is no inflation the bond price does not increase in price.  Interest is exempt from state and local taxes and there is a three month interest penalty if redeemed during the first five years.  I-bond holders can elect to pay tax each year or defer it for up to 30 years as they gain in value.

TIPS are a lot like conventional Treasury notes and bonds and their interest rate is paid on the inflation- adjusted value of the bond every six months.  An adjusted face value is announced monthly when the new CPI numbers are released.  As long as inflation occurs, the face value of TIPS goes up and the interest payments, calculated as a percentage of face value, go up.  If deflation occurs the face value of the bond will decline but never below the purchase price of $1000.  At maturity investors receive their final inflation-adjusted face value.  Just like conventional fixed income instruments with long maturities, TIPS are subject to price variation as market interest rates shift and factors other than inflation affect bond prices.  Investors pay Federal income tax but not state tax on all interest received each year plus on any gains in inflation-adjusted principal even though they will not receive that principal until the bond matures.  I-bonds and TIPS are available from Treasury Direct and are not typically held at brokerage firms except in mutual funds containing them.  Variations of these two securities are sometimes available in corporate form or in CD's.  General advisory opinion is that I-bonds are best held in taxable accounts due to the tax deferral option while TIPS are best held in tax-deferred accounts.

How well have inflation-adjusted securities done historically?  The best long-term data we have comes from the UK.  Though not identical, the structure of US inflation protected bonds and UK inflation protected bonds is similar.  Dimson et al found that for 1981 though 2000, UK inflation protected bonds underperformed conventional short, intermediate, and long UK bonds and even money markets.  Dimson et. al. (2003, Triumph of the Optimists) calculate a real return for inflation protected bonds of -1.25%, a decline.  In their 2012 update on inflation linked bonds (Credit Suisse 2012 Investment Returns Yearbook) they note that the real yield on inflation-linked bonds provides a forward-looking statement of inflation adjusted yield to maturity.  As investors fled to safety during the 2008 financial crisis, real yields on inflation linked bonds close to 10 years in maturity declined to zero and in several issues turned negative.  Thus, the most investors could expect from these bonds was the inflation adjustment offered by government statistical agencies and, as we note above, that adjustment is suspect and very likely significantly understates inflation.  Dimson et al, pretty much the gold standard for market returns, concluded that inflation protected bonds "can make little contribution to achieving a positive real return over the period from investment to maturity."

Let's compare returns for three Vanguard fixed income funds from January 2007 through January 2012.

The year 2011 was a very strong one for inflation linked bond appreciation as investors rushed into them out of fear over inflation.  This drove prices up and yields down close to zero or negative.  Short term bond yields dropped to record lows, largely due to the Federal Reserve's near-zero interest rate policy stimulus (i.e. debt).  When we first calculated the same fund comparisons back in early 2011 the five year returns for inflation protected securities indicated they had underperformed both short and intermediate bond indexes.  Both DFA and Vanguard offer inflation linked bond indices.

Larry Swedroe, (CBS Moneyline, 3-2-12) advocates substantial exposure to inflation protected bonds, noting that TIP's correlated with inflation at .21 for the 1997 through 2011 period.  This means that inflation only "explains" .21x.21 or about 4% of the price variation in TIP's, not much.  TIP's did reduce the standard deviation of a portfolio with 50% equity and 50% fixed income from about 10% to 8.5%.  Many proponents of inflation protected securities point to periods of strength.  In 2011, Vanguard's inflation protected fund, VIPSX, returned 14.5%.  Since the interest rate component of this return was in the 1% range, the rest of the return was due to a strong rise in bond prices due to declining interest rates.  This occurred even though the Federal Reserve viewed inflation as mild based on its metric using the "core" inflation rate.  The core inflation rate omits food and energy prices that seems like a significant omission since almost everyone consumers both.

Ang (Asset Management, 2014) presents data showing inflation protected bonds are poor inflation hedges.  For the March 1997 to December 2011  period he states, "TIP's and Treasuries tend to move together with a correlation of 64%, and the correlations of both TIPS and Treasuries with inflation are low.  Far from offering good inflation protection, TIP's correlation is just 10%".  From 2003 through 2011 the correlations of five, ten and twenty-year TIPS yields with inflation are negative, at -23%, -12%, and -13% respectively.  He opines, "Unfortunately at the time investors most desire high real yields-when inflation is high-they are not forthcoming."

As of March 2012, five and ten year TIPS were yielding -1.18% and -0.11% respectively.  The only future yield on these bonds was the inflation adjustment and, as noted above, BLS inflation data likely understates the true inflation rate.  Up t0 2021 yields were negative after inflation for high quality short and intermediate fixed income.  Brett Arend, a well-known journalist for the WSJ, published a piece on CBS Marketwatch on May 6, 2011 entitled "Holding TIPS will make your poorer."  In it he argued that TIPS are an investment guaranteed to lose investors money and notes with the yield at that date on five year TIPS around -0.5% investors were guaranteed a loss of 2.5%.  Only the inflation adjustment might make the return positive.  Stephen Foley (Financial Times 3-16-16) notes, "Wall Streeters who trade TIPS, Treasury Inflation Protected Securities, government bonds whose value does not erode with inflation, like to joke that the acronym stands for Totally illiquid Pieces of ...., (ask a trader)".

Although we don't have sufficient long-term data on US inflation protected securities to make statistically signficant long-term comparisons with conventional bonds at this point they don't appear promising for longer time frames.  It will take more time and data to determine if inflation linked bonds offer investors real value after inflation though they are likely to remain popular with many financial advisors.  Problems with CPI calculation methodology, the risk that downgrades in US Treasury debt will drive down prices, and varying investor demand for inflation protection make it difficult to determine how much protection these bonds actually will offer and what their total return is likely to be long-term.

CONCLUSIONS:  Historical data going back over 2000 years show that history is unquestionably inflationary.  Since 1926 the US dollar has lost about 97% of its purchasing power and there's little reason to expect its decline to stop or reverse.  There is every reason to expect that the US dollar will continue to buy less and less in asset markets or in a consumer's market basket of goods and services.  Stocks and bonds have always been paper assets priced in fiat government currency and vulnerable to the effects of currency inflation.  Today, even real estate prices have been affected by fiat currency since a good deal of the rise in housing prices in the US into their 2006 and 2020 peaks occurred as trillions in complex levered derivative mortgage paper priced in fiat currency drove up housing prices.  In 2016 housing prices again reached their 2006 peaks and in early 2021 housing prices continually hit new record highs based on "hope" for a big bull market continuing on top of the biggest most overvalued housing market versus incomes ever.  Prices have been driven by Wall Street and large investor involvement in housing markets, record low mortgage interest rates, and record high leverage with minimal required down payments and credit ratings.  Inflation protected bonds do not appear at this point to be an effective hedge against inflation.  Gold and commodities offer some long term inflation protection but returns can fail to appear for extended periods of time and many investors don't feel comfortable holding them.  As always, future economic and market events are unpredictable and thus so is inflation.