US TIPS vs Gold, Part 1: Understanding Inflation Is The First Step In Hedging It

The possibility of rising inflation on the horizon means investors should consider their hedging options. In this piece, we weigh up US TIPS vs gold alongside a detailed breakdown of CPI.

The long-term downtrend in US core CPI appears to have stalled, although it remains below the Fed’s 2% target level. Moreover, the Fed recently announced that it now believes that targeting an average inflation rate of 2% is preferable to holding it near that level, implying that a deliberate overshooting may reverse the undershooting of recent years. In this context, investors should consider how best to position for a persistent (if perhaps only moderate) rise in CPI in the next few years.

Two obvious inflation hedges are US TIPS, linked directly to US CPI, and gold. The former is indeed an effective hedge against headline CPI. However, for some investors, CPI may not be the most applicable benchmark for hedging against the real cost of living given that consumption baskets tend to shift, especially over longer periods of time. There are also non-inflation risks to consider, particularly for international investors. In such cases, gold is probably the better option versus TIPS.

Understanding Inflation

What is inflation? Prior to the 1930s, when economists discussed inflation, they normally meant increases in the money supply rather than the price level. The assumption, however, was that changes in the money supply would impact consumer prices in some way, if not necessarily 1:1, as per the venerable Quantity Theory of Money, normally written as MV = PQ, in which:

• M is the quantity of money
• V is the ‘velocity’ of money, that is, the rate at which money circulates
• P is the price level
• Q is the level of real economic output

While Milton Friedman and the Chicago School revived interest in the Quantity Theory during the 1950s and 60s, it received its most famous use as an active instrument of monetary policy in the early 1980s, when Fed chairman Paul Volcker reoriented US monetary policy around explicit monetary targeting. However, the point of money targeting was to bring down the rate of CPI inflation, which was running in the double-digits at the time.

Today, when economists talk about inflation, it is nearly always assumed that they mean the price level, which in the US is normally either the CPI or the deflator for personal consumption and expenditures (PCE) as estimated within the national GDP accounts.

The Evolution of the CPI

As TIPS pay coupons indexed to a principal amount that grows over time and, at maturity, investors receive back the adjusted principal that was linked to the CPI, we focus here on that measure of the price level. As with all economic aggregates, the CPI is estimated by compiling large amounts of data. Within the CPI there are numerous subcategories, each of which is given a weighting. Within each subcategory there remains a large basket of relevant goods, each with its own weighting within that basket. In all cases, the baskets and subcategories are reweighted occasionally based on estimates for how typical consumption patterns change over time. For example, wireless services used to be a negligible component of the CPI. Today, however, it comprises nearly 2% of the overall index.

If any of the above measurements, weightings, estimates and aggregation methodology seem at all subjective to you, of course you are right. No process of aggregating what happens in the real, objective world is possible without some subjectivity entering the process. As economist Roger Garrison once said, ‘Your aggregate IS your theory.’ The assumptions economists make don’t just influence how they see the economy: when it comes to creating an economic aggregate, they define the economy.

Perhaps the best example for how subjective the CPI can be is found in the way the calculation methodology has changed over time, including the introduction of substitution effects and so-called ‘hedonic’ adjustments within the index. The former is for when a given good rises in price, but a near-substitute does not. The CPI methodology assumes that when this happens, consumers will shift their purchases away from the more expensive to less expensive substitute good, thereby lowering the overall effect on the CPI. A classic example here would be steak and hamburger meat. If the former rises in price, consumers simply shift their purchases to the latter.

Hedonics are even more subtle, more subjective and so probably even more controversial adjustments to the CPI methodology. Introduced in the 1990s, they attempt to adjust for increases in the quality of consumer goods over time. For example, computers may not get less expensive, but they may get more powerful. In this case, hedonic adjustments would imply that the ‘price’ of computers had fallen as a result. Cars may not get more expensive, but they might get better fuel mileage and be safer. Here, too, hedonics would imply that their prices are falling. (Intriguingly, hedonics are not applied to the reverse effect, that is, were the quality of some good or service to decline over time, for whatever reason.)

How Relevant is the CPI?

The obvious problem with adjustments such as these is that they introduce even greater subjectivity into a calculation methodology that was already subjective. While for a majority of consumers, the CPI might nevertheless do a good job tracking their real, effective cost of living, for a sizeable minority, it might not. This is why the decision to use TIPS and/or gold to hedge against increases in that cost of living matters a lot, in our view.

Take, for example, the huge divergences in trends within the CPI subcategories in recent years. When it comes to goods that can be manufactured abroad and that are therefore subject to significant international competition, there has been essentially zero price inflation and, in some cases, outright deflation for years, as seen in clothing and computer prices (Chart 1).

However, when it comes to domestic services, in particular education, childcare, healthcare and other highly regulated sectors subject to little if any international competition, price increases have been running at much higher rates (Chart 2). Consequently, a household with teenage children, particularly one in which the parents are too young to qualify for Medicare or other government-funded healthcare, might well have faced an effective inflation rate of double or more versus the average annual CPI in recent years. So, during this period, the TIPS-implied inflation protection would not have provided enough of a hedge against the erosion of real, effective purchasing power.

However, during the same period, an old, retired couple with no children and with access to government-funded Medicare and other programmes available to senior citizens might well have experienced a near-zero average increase in their cost of living. And any month-to-month changes in often volatile energy and food prices would have been effectively hedged by TIPS.

For the latter household, therefore, TIPS might be an ideal way for them to protect themselves. It’s possible that TIPS on a breakeven basis might even outperform the overall increase in their actual, effective cost of living. Furthermore, if the Fed delivers on its policy framework by allowing the CPI to run over 2% during the coming years, any future increase in the CPI could disproportionately benefit demographic cohorts that consume baskets that are structurally lagging and lower than the headline CPI print or that are in a persistent state of disinflation. However, for the former, younger household example above, not only would TIPS have failed to cover their cost of living increases of recent years, they will be almost certain to fail, and possibly by an even greater magnitude, in the years to come.

A recent paper by Harvard professor Alberto Cavallo, Inflation with COVID Consumption Baskets, found that changing patterns of consumer expenditures is indeed resulting in many consumers experiencing much higher inflation than what the official US CPI measure publishes, especially during this pandemic period. Cavallo also was able to validate that such deviations are occurring in other countries too. Furthermore, he found that lower-income households are suffering the brunt of such price increases (especially around essential core items) versus higher-earning households. It is therefore entirely fair to consider that during this recent period TIPS would not be an ideal hedge for all households as well.

In our next report of this series we will explore how gold might be a better hedge than TIPS. This will be useful for those households disproportionately affected, either from longer-term trends or the impact of Covid more recently, or simply concerned about the possible impact of sharp rises in their effective cost of living during the coming years. We will also consider whether gold might be more suitable for international investors, with no direct exposure to US CPI, yet subject to other potential risks.