I Bonds and the Federal Reserve

Yesterday the Federal Reserve issued a statement about its intentions regarding inflation. The goal is 2 percent, as measured by the price index for personal consumption expenditures, which is also known as the PCE. Here’s the relevant text from that statement:

The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate.

Separately yesterday, in the official FOMC or Federal Open Market Committee statement, the Federal Reserve said it expected to keep the target federal funds interest rate at 0 to .025 percent through at least late 2014. Here’s the relevant text from that statement:

…the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.

The combination of these two statements is favorable for I bonds. The inflation target tells you what you might expect to earn on your I bonds. The interest rate target tells you what you might expect to earn on alternative interest-bearing investments. I bonds are the clear winner here, whether you are currently invested in them or make a new investment. The announcement should also be favorable to those already invested in TIPS (not so much for new investors, however), because the lower the TIPS rate goes into negative territory, the higher the price on existing TIPS.

This particular combination of rates and inflation means the Federal Reserve is trying to create negative real interest rates (that is, the interest paid is less than the inflation rate, which means investors lose money at the expense of creditors, like those too-big-to-fail banks leveraged at 35-to-1). While in the big picture this is more of the same picking the pockets of the small investor to protect the financial system (read the folks at the very tip-top of the income/wealth pyramid), in the smaller picture I bond investors should do better than others in the near term because they are protected from inflation. And they’ll continue to do better than new TIPS investors because the fixed rate on I bonds can’t be negative.

Moreover, the Federal Reserve’s choice of the CPE over CPI as an inflation indicator is interesting. I bonds earn the CPI, while the Fed is targeting the CPE. The CPE tends to run lower than CPI, so we can expect the CPI to be somewhat higher than 2%. Here’s a rough graph showing the annual trends in CPI and CPE in the 1929 to 2010 time frame.