Someone is really wrong about Inflation and Economic Growth

Treasury Inflation-Protected Securities (more commonly called TIPS) are the inflation-indexed bonds issued by the U.S. Treasury. Their purpose is to protect the bond owner against inflation. TIPS’ principal is adjusted based on the Consumer Price Index (CPI). When the CPI rises, the bond principal increases. If the CPI falls, the principal decreases. TIPs’ stated interest rate is constant, but generates a different interest amount because the principle amount of the bond changes with inflation. TIPS are currently offered in 5-year, 10-year and 30-year maturities.

Last week, the U.S. sold $13 billion in 10- year TIPS at a record low negative yield of .089 percent. The Treasury Department reported that large institutions, including foreign central banks, bought about 39% of Monday’s TIPS offering.

Stagflation describes when the inflation rate is high at the same time as economic growth rate is slow and unemployment is high. In Keynesian macroeconomic theory (currently in favor with the Obama Administration and Federal Reserve), inflation and recession are regarded as mutually exclusive over the 5- and 10-year terms covered by the TIPS’ maturities.  When stagflation occurs, fiscal policy (i.e., deficit spending) and monetary policy are both difficult to implement without increasing either inflation and/or  unemployment.

Practically everyone can agree that the negative yield on TIPS is not sustainable. Someone is making a big mistake. The yields on the 5- and 10- year TIPS have been negative since roughly the beginning of the year, but the negative spread is increasing. Those buying these TIPS are seeking the security of Treasury investments for these intermediate terms (presumably because of a lack of faith in the U.S. economy over this term), but also believe that that inflation expectations built into regular Treasury yields are incorrect. Those currently purchasing TIPS are betting that the U.S. is headed towards stagflation.

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