In addition to regular Treasuries, the US government also offers Treasury Inflation-Protected Securities: TIPS. These are interesting beasts, in more than one way.
Let's say you buy a 1000 dollar 1-year Treasury, the ordinary kind, and you manage to pay 952.38 for it. So, the initial rate is 5%. You gave a bit of money to the government for one year's safe keeping, and after the end of that period, you expect to get that money back plus 5%.
But over the course of that year, the government decides to print cash to pay its bills. Prices rise by 10% over the year. So at the end of the year, you have 5% more nominal cash but in terms of real purchasing power you've actually been screwed. You did the government a service by lending them money, and they penalized you for doing so.
This basically describes the 1970s and early 80s.
For the next go-round, you're going to want a buffer. Inflation expectations are much higher, so you're going to be more careful about it. At the next auction, you're willing to pay 869.57 for a nominal interest rate of 15%. You're not willing to pay more than that amount because the higher you bid up the bond price at the auction, the lower the interest rate you receive. At a bond price corresponding to 15% interest, it seems okay. Given expected inflation of 10%, you will make your real rate of 5%. There is inflation, but the money you get back should still buy more stuff than the money you lent them. That's a real return.
When financial institutions buy bonds, they think about these sorts of issues. Right now the yield on 1-year Treasuries is 0.17%. Inflation expectations are currently around 1.75% according to one common market measurement (see below).
People are lending money to the government with the full expectation that they will be paid back in cash that is worth less than what they originally lent. This is not a surprise penalty, unlike the unexpected inflation of the 1970s. They do this consciously, eyes wide open. They want safety. This is the best deal they can get on the safest asset around.
It's good to be the king. The US government can borrow money, pay back less than what it borrowed, and everyone is satisfied with the transaction. Amazing.
But maybe inflation will finally rise. For those who are concerned about unexpected inflation, they can rely on TIPS. If inflation is higher, TIPS bonds must pay more money to compensate for that loss of value. The payments are linked to the Consumer Price Index. If you buy a 10-year TIPS bond at a 2% rate, and inflation is 10%, then you should receive 12% when it's done. Basically. We can skip the actual calculations.
For TIPS maturing in two years, the current yield is -0.611%. This is to say that if you buy the bond today -- and inflation remains as expected -- you will literally pay more cash out of your pocket than the government will give you back after two years. Safety. The "real" interest rate for two year borrowing right now is actually negative.
My policy is to look at market signals. Here is one of the most important.
We look at regular Treasuries. We look at TIPS. For clean numbers, let's say regular Treasuries are yielding 4% annually over ten years, and TIPS are yielding 2% over ten years. Both securities are issued by the same government. Both have essentially the same default risk. One is indexed to inflation, the other not, but they have the same maturity. Which means that the difference between the two yields is the expected inflation rate. Even in theory, this isn't a perfect expected inflation signal. It's a little rough around the edges, but still, it's pretty good. I don't know what inflation will be, but this is the figure I look at first. This is the market signal. The difference in yields between the two kinds of bonds is called the breakeven rate.
The Fed has an implicit inflation target of around 2%. During the financial crisis, the 10-year breakeven hit a low of 0.04%. That should basically never happen with a 2% inflation target. It means that everyone expected them to miss their target. They can print money, and everyone expected them to miss their target. I say this is strong evidence that something was seriously wrong with Fed policy. I say further that they have not learned adequately from their mistake. Europe is even worse.
I have returned to the university. This is what I focus on. We're getting into some juicy stuff now.
You, the reader of this 100-part series, now have a tool available which you could use to do (one aspect of) central bank policy significantly better than at least some central bankers are currently managing to do themselves.
The European Central Bank is supposed to be bound by law to achieve "price stability", defined as inflation over the medium term at close to, but less than, 2%. Core inflation in the eurozone is closer to a half percent. If you were in dictatorial control, you could ask your advisers for a policy that they believe would increase the inflation rate. Then you could have a press conference and announce the policy. Then you could check the breakeven. If it's significantly less than 2%, then you already know the policy is expected to fail.
You ask for another plan from your advisers to do more. They give you another plan. You announce it again. You check it again. You keep doing this until the market expectation matches the legal requirement. You update your beliefs based on new information. Simple. It might be prudent to get a second opinion, so you could also ask the central bankers for the inflation estimates of their own macroeconomic models. This is fine, too. You keep changing your plan until the forecast matches the legal requirement. The rule is: target the forecast.
(This is actually a leeeetle harder to do in Europe from market signals since there are many countries with many different bonds. You can't just check Germany's breakeven price, by itself, and get a good reading of the whole eurozone. But the basic idea should be clear.)
The ECB has a legal target. They are missing their target. When they check the markets, and even their own models, the information they receive says that their current actions are grossly insufficient to meet their own legal mandate. They respond to this information by doing... nothing. Just nothing. I'm not a huge fan of QE as it's currently practiced (more later), but in the US, the Fed started its first QE program in 2008 soon after the Lehman shock. Many countries in the eurozone are mired in a depression that's been longer and more severe than even the Great Depression of the 1930s.
And the monetary response? The ECB's first QE program was just a couple weeks ago. 2015 was their first proactive measure taken against a crisis that began in 2008.
When I say that the European Central Bank is incompetent, I want my full meaning to be clear. In the centuries of central banking history on this planet, the technocrats at the highest level of the ECB are quite possibly the worst there has ever been. At least Mario Draghi represents a shift in a slightly better direction.