wmeubank@ocp.kcmo.com
THE U.S. POLITICS OF INFLATION
FISCAL AND MONETARY POLICY
Prepared by Technical Data
A Division of Thomson Financial Services
Just as the U.S. Treasury's new inflation- indexed bonds are attracting a following, a debate is heating up over whether the U.S. Consumer Price Index (CPI) is upwardly biased and in need of revision. The motivation to fine tune the index isn't political, say the experts, but rather is guided by a desire to "do the right thing." One feature of the recent "historic" agreement to balance the federal budget deficit is a tacit agreement by Congress and the White House not to interfere with any downward adjustments the Bureau of Labor Statistics makes to the CPI. However, would the political establishment be as keen to re-calibrate the CPI if all the experts agreed that CPI actually understated inflation?
Is it just coincidental that a downward revision in CPI would translate into a tax increase and a reduction in inflation-adjusted payments to Social Security, welfare, and other Federal entitlements? Republican House leaders are ready to look the other way if CPI is adjusted downward (a stealth tax increase for everyone). In exchange, they get explicit tax cuts of $1.33 billion in capital gains, estates, and family tax credits for children and college tuition. What? Moreover, it remains to be seen whether Republican Congressional leaders will put up a fight to index a capital gains tax cut for inflation as their current proposal calls for. By contrast, President Clinton has stated that he is adamantly opposed to indexing capital gains taxes for inflation because he claims it would cost too much in lost revenue to the government. Why shouldn't capital gains be indexed to inflation when other taxes and entitlements are? Isn't it only fair to measure all forms of taxation by the same yardstick? Some deal! The de facto tax increase implied by a downward revision in the CPI could in effect trim the $133 billion in targeted tax cuts by an estimated $31 billion in inflation adjustments by the year 2002 if CPI were adjusted downward by one-quarter of one percent (.25%) starting in fiscal year 1998.
Instead, how about leaving CPI entirely alone especially if, as the "experts" claim, it overstates inflation. If it does overstate inflation, it means that the economy has been benefiting from an unintended incremental tax cut every year since 1981 when income taxes were indexed to inflation to put a halt to bracket creep. In other words it may be that the upward bias in CPI has been inadvertently overcompensating taxpayers for the impact that inflation has had on what they owe in taxes. Perhaps this factor partially explains why the economy has been humming along so briskly in recent years despite big tax increases in 1990 and 1993 from Presidents Bush and Clinton. If so, it lends support to the argument that tax cuts stimulate economic growth and pave the way for a broader tax base. Windfall tax receipts are pouring in for no apparent reason, and the budget deficit continues to weigh in lower than all forecasts. This, notwithstanding the fact that the alleged inflated CPI also is responsible for making excessive payments to CPI-indexed entitlements. The White House and Republican Congressional leaders should act quickly to ratify their historic deal and claim political credit for it, before the budget deficit disappears all on its own without any help from them. Of course, this assumes that any deal they make doesn't de-rail the current performance of the economy and tip it into a recession, which would cause the budget deficit to increase again as tax revenues dry up and entitlement payments go through the roof.
Just as taxes and entitlements are affected by changes to the CPI, so too are recalculations for the underlying principal in the new CPI-indexed Treasury notes. This fact raises some concern about whether the inflation-indexed notes are subject to political manipulation. An alternative approach could use gold as an inflationary hedge by offering investors the option to receive interest payments and redemption of principal in either U.S. Dollars or a fixed weight of gold based on its price at the time of auction. Alan Greenspan himself promoted exactly such a financing vehicle as early as 1981 in a Wall Street Journal editorial and suggested that the Treasury would be able to sell such instruments at 2% to 3% coupons at a time when Treasury debt was yielding rates in the low to mid-teens. Recent analysis of the front end of the yield curve suggests that embedding Treasury debt with such a gold option would garner inflation-proof yields in the range of only .50% to .75% in the three- to six-month maturities and something like 3.25% in the two-year sector. These inferred real rates of return would of course vary as implied volatility in the gold options market fluctuates.
However, aside from offering attractive borrowing rates, this financing vehicle would also provide a clear signal to the Fed regarding monetary policy. If holders of gold-indexed notes perceived an inflationary threat, they could choose to redeem their interest and principal payments in gold and would drain reserves from the system as a by product. Conversely, if investors sensed deflation they could be expected to opt for receiving interest and principal in currency rather than gold, thus adding reserves to the system. In effect, this option would in part take monetary policy out of the exclusive hands of the Fed and transfer some of it directly to the market forces, i.e., buyers of gold-indexed Treasury debt. No one can doubt that the Greenspan Fed has done a superb job on reducing inflation. Nevertheless, should the health of the world's financial markets hinge on the subtle nuances of such an elite group? No matter how good Greenspan & Company are, the modus operandi of the Fed somehow reminds me of centralized planning.
July, 1997 Ed Rombach, Derivatives Specialist
Technical Data
A Division of Thomson Financial Services
22 Pittsburgh Street, Boston, Massachusetts
Added to the WWW 07-05-97
Last updated on 07-05-97
Hosted by:
One Crossroads Place
610 West Maple Ave, Suite WWW
Independence, MO 64050
(816) 252-4080
sysop@kcmo.com