Inflation and TIPS 101

I am very concerned about inflation and this is a theme that I plan to be coming back to it regularly. Here, I want to first give, for those who are not familiar with, some definitions of inflation and then to introduce a class of assets that provide (perhaps) a hedge against inflation, the Treasury Inflation-Protected Securities (TIPS). The reason is to clarify some differences among different inflation measures and where perhaps each of them is used and also to dispel the misunderstanding that exists with respect to which measure of inflation do TIPS use and more specifically whether food and energy prices are included in it.

Unfortunately, there are many inflation measures and they differ on the composition of the asset basket for which prices are used in order to find the level of the Price Index, which then will result to the corresponding inflation measure. Inflation is the rate of change of the Price Index of each corresponding basket. Usually inflation is measured in a monthly frequency, as it is not feasible and perhaps it is not necessary to measure at a higher frequency.

The two inflation measures that matter for us are the Core Inflation and the Headline Inflation (CPI-U). What matters for us, as consumers, is the Headline Inflation because it incorporates the prices of more consumption goods – and goods that are broadly used – than the Core Inflation. Notably, the Core Inflation does not include food and energy prices. This is done because their prices are more volatile and they are more susceptible to short term supply shocks that can make a measure that includes them deviate substantially in the short term from a long term trend. Economists, and especially FED macro-economists, who want to gauge inflation dynamics in order to form monetary policy, need to base their policies on stable price trends and not on transitory effects, filter out these deviations – or “noise” around the trend – by focusing on the Core Inflation measure.

Why does the FED focus on Core CPI?

Different websites and even popular press takes this wrong hinting on negligence or conspiracy. The truth is far from that. The answer is that transitory deviations from the true CPI trend would give a lot of false signals to the monetary authorities and this would result to a huge distraction of value in the economy. This can be understood better with the help of the following example that I borrow from an anonymous source.

Suppose that the Federal Reserve had a mandate to stabilize the full Consumer Price Index, and that food prices suddenly doubled. To keep the CPI at a stable level, other prices would need to decrease. The problem, however, is that many prices are sticky, meaning that they do not instantaneously respond to changes in monetary and macroeconomic conditions. This is especially true in the service industry (which comprises the bulk of both GDP and the CPI).

To create these compensating price changes within a relatively short timespan, the Fed would have to impose extremely tight monetary policy, with sky-high nominal interest rates. And as we saw in the early 1980s, a large increase in nominal interest rates is extremely destructive to the real economy, leading to a massive increase in unemployment. Given our already weak economic conditions, such a policy would be even more damaging today.

Core CPI is a way to prevent this kind of needless suffering and unemployment. By targeting a more stable set of prices, the Fed avoids the wild swings in monetary policy that would inevitably arise from targeting an index that includes commodity prices. In other words, the demagogues who assail core CPI have it all wrong: the average American would be much, much worse off if the Fed targeted a volatile measure like headline CPI.

For more on CPI’s and their performance see here, here, here and here.

What are TIPS?

TIPS are Treasury Inflation-Protected Securities. They are bonds that have a fixed interest rate (coupon rate) which is determined at their auction, but they differ from Treasury bonds, in that their face value fluctuates positively one-to-one with the CPI. What I want to clarify here that is confusing to a lot of people is what is the CPI measure that is used for the face value. Several people spread around that this is the core CPI which is not correct. It is the CPI-U or Headline CPI that is used – that includes food and energy – in order to compute the TIPS face value. This is stated explicitly on the Treasury’s website. A question one may have is how does the Treasury come up with the future face values since they announce ahead of time the Daily Index Ratio for the next month. The answer to that is that they do a three month rolling average, extrapolating for the next one month period. The interesting remaining question is, how do they come up with daily CPI-U? I will respond to that when I find the answer.

To conclude, there is no cheating in the way TIPS have been constructed, as the belief that TIPSs face values do not reflect real inflation is not correct.

Roubini On Risks

Euro Under Attack

A video about the crisis in the Eurozone. The inside story of important events during the Eurozone crisis. Appear, Jean-Claude Trichet, George Papaconstantinou, Jean-Claude Juncker, George Soros, Christine Lagarde, Olli Rehn, and others. It is in French, with Greek subtitles.

Oil Prices And Recessions. Double Dip?

I take some facts, about the role of oil prices in the economy, from the article of Roubini on FT found here.

“About two-thirds of the world’s proven oil reserves and almost half of its gas reserves are in the Middle East.”

“Three out of the past five global recessions have followed a Middle East geopolitical shock that led to a spike in oil prices. In the other two global recessions, oil prices also played a role.  The Yom Kippur war of 1973 triggered a sharp increase that led to the global stagflation – recession cum inflation – of 1974-75. The Iranian revolution in 1979 led to a similar stagflationary rise in oil prices that triggered the 1980 recession (a double-dip recession for the US in 1980 and 1982). The Iraqi invasion of Kuwait in August 1990 led to a spike in oil prices at the time when the savings and loan crisis was already tipping the US into a recession; the US and most advanced economies then entered a short recession that lasted until the spring of 1991, when the war against Iraq was won. Even in the 2001 global recession – triggered by the bursting of the technology bubble – oil played a modest role as the second Palestinian intifada and broader Middle East tensions led to a modest but significant increase in prices.”

“Oil prices were also significant in the most recent global recession. The US entered a recession in December 2007 following the subprime bust, but this became global only in the autumn of 2008. This global recession was not triggered only by the collateral damage of Lehman’s bankruptcy. By the summer of 2008, oil prices had doubled in about 12 months, reaching a peak of $148 a barrel. That was a massive negative terms of trade and real income shock not just for the US, most of Europe and Japan but also for China and all the other net oil/energy-importing emerging markets. An already fragile global economy was tipped into an outright global recession.”

“This rise – and the related increase in other commodity prices, especially food – pushes up inflation in already overheating emerging market economies where oil and food prices represent up to two-thirds of the consumption basket.”

“But if oil prices were to rise much further, these economies would slow down sharply and some might even experience a double-dip recession. Finally, rising commodity prices increase investors’ risk aversion and may lead to a reduction in consumer and business confidence that is both negative for financial markets and the real economy.”

Credit Crisis Explained

Those At The Nucleus May Not Have The Best View

A really great article, full of truths about different things. The article is here, written by John Kay of FT. Here are some quotes from the article that I find worth mentioning .

“I was disappointed to find that the most distinguished of my lecturers, the economist Sir John Hicks, had never mastered how to hold the attention of a class. But clarity of thought and clarity of expression tend to go together. The best textbooks are often written by the best researchers: Richard Feynman could not only do physics brilliantly but also brought it alive with words.”

“… few people are as irritating as those whose combination of ignorance and arrogance is so profound that they claim to understand things they do not even know they do not know. The world of business and finance, which values confidence and certainty, is full of such people. “It isn’t really like that,” they will say; and when you ask what it is really like, they will tell you it is too complicated for you to apprehend. What they really mean, but do not recognize, is that it is too complicated for them to apprehend.

The bad financier, or businessman, like the bad scientist, pursues complexity almost willfully because he believes such complexity demonstrates his knowledge and sophistication. So the blind lead the blind through the mysteries of structured financial products and the jargon-ridden thickets of corporate strategy. People sell securities whose properties they only dimly appreciate to people who do not understand them at all. Consultants describe the business world in language – and, of course, PowerPoint presentations – whose elaboration disguises the banality of the thought.”

“Perhaps Henry Ford and Bill Gates were the men who really understood the automobile and computer industries, or perhaps they were just the people whose opinions turned out to be right, which is not the same at all.”

EU Commission Authorities Protecting The Greeks

We should thank the European Commission competition authorities for doing the obvious, something that the Greek authorities did not do, for the usual reasons of collusion and corruption. I am of course talking about the proposed merger between two of Greece’s largest airlines, Aegean and Olympic Air. The competition authorities declined the proposition on the grounds that it would create a monopoly. They state,

“This would have led to higher fares for 4 out of 6 million Greek and European consumers traveling on routes to and from Athens each year.”

It is interesting that the commission rarely uses its veto on mergers. You may read the article here.

Burton Malkiel’s Interview About Efficient Markets

The Stock Market Is Here

It has been a great come back! Motivated by today’s crossing of DJIA of the 12,000 level, which with certainty is going to be heralded in the media, I wanted to remind a few facts. First, where were we before we get into this mess? We (DJIA) hit a level of 14,093 on October 8, 2007. Then we landed at 6,626 on March 2, 2009, and since then we have been going up and up until today we crossed the 12,000 mark. If you ask me where it is going to go, I will have to say that “I do not know”. However, it is more likely that will go higher than lower. Apart from the ongoing slow worldwide economic recovery, an important factor that can affect significantly the “near” future market returns is the positive feedback by the media. The index is climbing higher with no big hiccups and quite low volatility, VIX is at  16.71, a level we crossed, moving upwards, in July 2007 and we revisited in October 2007, as well as a few other times since then, which was the market’s high. For all these reasons, I see an upward movement in the overall market as being more probable than otherwise, even though the fact that we have not seen any serious disruptions in the up-trend makes me cautious. The market is back, good news come from a lot of directions, the news will be heralded, the hype may catch on again, the market probably will continue higher, but be cautious about when a correction, or a turn may come. The turn is not very probable. For it to happen, the bad news will have to be quite significant.

Sheer Regulators’ Incompetence

The failures of SEC in identifying Ponzi schemes or even following up after people pointed them out to the authorities are known and monumental. So, perhaps one more failure would not be of surprise or worthy to be mentioned. However, here I report the latest one, the failure to uncover a 500 million Ponzi scheme run by Westridge Capital Management that lasted more than a decade, in Los Angeles.

Other notable failures of SEC officials to uncover such practices include the Madoff scandal. Here are some older articles on the subject. Article 1, article 2.

With all this new regulation in place, the question that we still have to answer is who is going to do the job. It is not merely a matter of less regulation, but of sheer incompetence of people to perform their tasks, that brought us, to a big extent, where we are today.

A Paper on Greece’s Woes

My appointment at NYU has taken a toll on my time devoted on this blog. However, here is a paper I meant to include in the information about Greece’s economic problems. The article, written by well known academics Meghir, Vayanos and Vettas, not only identifies the causes of the Greek crisis but also proposes measures in order to get out of it as fast as possible. Hope you enjoy it.

Bar Stool Economics

This fictitious story has circulated a lot through emails, however I find it worthwhile to be posted here. 

Suppose that every day, ten men go out for beer and the bill for all ten comes to $100. If they paid their bill the way we pay our taxes, it would go something like this:

The first four men (the poorest) would pay nothing.
The fifth would pay $1.
The sixth would pay $3.
The seventh would pay $7.
The eighth would pay $12.
The ninth would pay $18.
The tenth man (the richest) would pay $59.

So, that's what they decided to do. The ten men drank in the bar every day and seemed quite happy with the arrangement, until one day, the owner threw them a curve.
"Since you are all such good customers", he said, "I'm going to reduce the cost of your daily beer by $20". Drinks for the ten now cost just $80.
The group still wanted to pay their bill the way we pay our taxes so the first four men were unaffected. They would still drink for free. But what about the other six men - the paying customers? How could they divide the $20 windfall so that everyone would get his "fair share?"
They realized that $20 divided by six is $3.33. But if they subtracted that from everybody's share, then the fifth man and the sixth man would each end up being paid to drink his beer. So, the bar owner suggested that it would be fair to reduce each man's bill by roughly the same amount, and he proceeded to work out the amounts each should pay.

And so:
The fifth man, like the first four, now paid nothing (100% savings).
The sixth now paid $2 instead of $3 (33%savings).
The seventh now pay $5 instead of $7 (28%savings).
The eighth now paid $9 instead of $12 (25% savings).
The ninth now paid $14 instead of $18 (22% savings).
The tenth now paid $49 instead of $59 (16% savings).

Each of the six was better off than before. And the first four continued to drink for free. But once outside the restaurant, the men began to compare their savings.
"I only got a dollar out of the $20," declared the sixth man. He pointed to the tenth man, "but he got $10!"
"Yeah, that's right," exclaimed the fifth man. "I only saved a dollar, too. It's unfair that he got ten times more than I!"
"That's true!!" shouted the seventh man. "Why should he get $10 back when I got only two? The wealthy get all the breaks!"
"Wait a minute," yelled the first four men in unison. "We didn't get anything at all. The system exploits the poor!"
The nine men surrounded the tenth and beat him up.
The next night the tenth man didn't show up for drinks, so the nine sat down and had beers without him. But when it came time to pay the bill, they discovered something important. They didn't have enough money between all of them for even half of the bill!

And that, boys and girls, journalists and college professors, is how our tax system works. The people who pay the highest taxes get the most benefit from a tax reduction. Tax them too much, attack them for being wealthy, and they just may not show up anymore. In fact, they might start drinking overseas where the atmosphere is somewhat friendlier.

Beware Of Greeks Bearing Bonds

Here is the article by Michael Lewis on the Greek crisis and its origins. A very good read.

Alekos Papadopoulos’ Truths

Still, after more than 12 months since the beginning of the crisis in Greece, Greeks do not want to realize the situation they are in. Alekos Papadopoulos though, ex minister of finance, takes up the role of letting the public know how bad the situation is in Greece – something the politicians still do not want to reveal to the public -- and what is needed in order to to have a chance after many years of austerity and recession. Here is a must read article of a short version of  Alekos Papadopoulos talk at ELIAMEP, in Greek.  The whole speech can be found here. Some of the measures he proposes are:

“Σύμφωνα με μελέτες, το 30% περίπου του σημερινού κράτους είναι περιττό. Γι’ αυτό πέρα από τις καθολικές αποκρατικοποιήσεις των δημοσίων επιχειρήσεων προτείνω όλως ενδεικτικά την άμεση κατάργηση τμημάτων πανεπιστημίων και ΤΕΙ, δημοτικών επιχειρήσεων, ατροφικών νομικών προσώπων δημοσίου και ιδιωτικού δικαίου, άεργων διπλωματικών αντιπροσωπειών, στρατοπέδων, συγχώνευση μητροπόλεων, κατάργηση απολιθωμένων κρατικών υπηρεσιών, αποκεντρωμένων υπηρεσιών και γενικών γραμματειών διαφόρων υπουργείων. Περιορισμό του μεγάλου αριθμού στρατηγών, ναυάρχων, πτεράρχων και ταξιάρχων των ενόπλων δυνάμεων και των σωμάτων ασφαλείας, περιορισμό του πολυάριθμου διδακτικού προσωπικού με αύξηση των ωρών διδασκαλίας, δραστική περικοπή κατά 70% τουλάχιστον των πολυάριθμων Γενικών Διευθυντών και Διευθυντών υπουργείων και οργανισμών, δραστική μείωση του μεγάλου αριθμού των αντιπροέδρων των Ανωτάτων Δικαστηρίων και τέλος εξορθολογισμό ή κατάργηση και άλλων πολυάριθμων αφανών δημοσίων καταλυμάτων, τα οποία περιθάλπουν χρόνια τώρα τον κρατικό ανορθολογισμό”.

Two Opposite Articles On WSJ

Here are two opposite articles on WSJ published on the same day. The first one, accuses the FED’s policy for bringing into a difficult position Brazil and the rest of the world, and even accuses the U.S. for mindlessness and purposeful action to damage the other countries. The second one, explains that buying medium to long-term Treasuries is a valid monetary policy of the FED in order to stimulate the economy. The first one is written by a journalist. The second one by Alan Blinder, economics professor at Princeton. Who speaks logic is your call. Just read them.

World’s Debt

The above picture, published in the Economist shows the levels of government debt in 1932 and 2009. Another very interesting interactive page provided also by Economist, is the one that shows the levels of debt as well as the the measures of debt per person and the debt as % of GDP, for the globe for the last 11 years. It can be found here.

The Evolution Of The Greek Debt From The 60s

Greece’s 2010 Deficit At 9.3%

Greece’s deficit for 2010 has been revisited upwards to 9.3%, much higher than the 7.8% target for 2010. An article in Greek.

China’s Dagong Credit Rating Firm Lowers U.S. Credit Rating

China’s Dagong credit rating firm lowers U.S. credit rating from AA to A+. At the same time Moody’s rates the U.S. credit at AAA, the highest credit rating according to the same firm. You can read about today’s developments on Bloomberg, on Barrons, on MarketBeat and other sources.

Even though the reasons why the credit rating of the U.S. may come under pressure is self evident, it is interesting to see how the articles treat the downgrade by the Chinese firm. They clearly state that their downgrade may be politically motivated and connected with the exchange rates war that is currently ongoing.

Bloomberg’s article mentions that Dagong’s application to become a Nationally Recognized Statistical Rating Organization in the U.S. was denied by the SEC. And Barron’s article mock’s the logic of Dagong’s report that the U.S. has been using the “virtual” financial economy to improve its GDP numbers.

El-Erian On Bloomberg About Greece

In a conference organized by the magazine Economist El-Erian, the CEO of PIMCO, talked about the choices of Greece and the likelihood of default. The Bloomberg article can be found here. In El-Erian’s own words:

“It’s in Greece’s interest to default as long as you can contain the contagion to other countries and it is done through orderly restructuring and repricing to retain competitiveness. Like Latin America’s “lost decade” in the 1980s, the alternative doesn’t promise growth and employment generation,” he said.

“I have never seen an 11 percent adjustment on the fiscal side being delivered” under the current program’s assumptions, said El-Erian, who worked at the IMF for 15 years. “Eleven percent is heroic.”

“The fiscal adjustment that Greece needs to do is unprecedented,” Giada Giani, senior European economist at Citigroup Inc., said at a conference in Brussels today. “There is a limit to the amount of fiscal tightening a country can bear and support without the tightening becoming self-defeating, so detrimental for economic growth that it doesn’t really deliver an improvement.”