Price inflation plays a major role when it comes to the value of money, particularly in the long term. In fact, according to AIER’s most recent CPI (Consumer Price Index) update, it now takes about $1.30 to buy what $1 bought 10 years ago.

When it comes to investments, however, taxes also play a powerful role in eroding returns.

The first chart shows the impact of price inflation and taxes on the yields of 10-year Treasury securities since the 1950s. Ten-year Treasuries’ nominal (or apparent) yields escalated through the 1970s and peaked in 1981. They have decreased since then to 4 or 5 percent for most of this decade. 

Source: Federal Reserve Board. Click to Enlarge Chart.

When nominal yields are adjusted for price inflation, the resulting real yields show a different pattern. Major discrepancies between nominal and real yields appeared in the 1970s, when price inflation was in double-digit territory. Nominal yields kept pace, but real yields (nominals - the rate of inflation) were at times actually negative.

This painful pattern—negative real yields—recurred in the beginning of 2008 and lasted 10 months, as a byproduct of the Fed's push to lift the economy out of recession by keeping interest rates close to zero.

When income taxes enter the picture, the returns are even lower. Assuming the highest marginal tax rates for investment income, in the 1950s about 90 percent of the returns was taken in taxes. In the 1960s and 1970s, the top rate was about 70 percent. Although the current highest rate is more favorable, investors still have to pay taxes of 35 percent on the income from their investment.

The combined effect of price inflation and taxes under these assumptions is shown by the green line in the chart above. In "normal" times, the after-tax real return on 10-year Treasuries is negligible (one or two percent) or actually negative. This has been a consistent pattern beginning in the early 1980s. 

These are not normal times. As the the second chart shows, real and after-tax real yields on 10-year Treasuries have suddenly risen to about 5 and 4 percent, respectively. As sky-high energy prices have come down over the past year, the measured CPI has fallen by about 2 percent. The effect, paradoxically, is to raise the real return on these notes—even after taxes. 

Source: Federal Reserve Board. Click to Enlarge Chart.

The temporary price deflation of the past year or so has boosted real yields to the highest level on record. Even after income taxes, to repeat, real yields on 10-year Treasuries are as high as nominal pre-tax yields. 

However dramatic, this outcome is likely to be only temporary, an artifact of the effect falling oil prices have had on measured price inflation. When things get back to normal, the CPI will resume its upward climb.

One way to protect Treasury bonds from price inflation and taxes is to invest in Treasury Inflation-Protected Securities (TIPS) and keep them in an IRA or other tax-deferred account until you are in a lower tax bracket. (The latter strategy might backfire, however, if you find yourself in a higher tax bracket down the road.) AIER has a more detailed analysis of TIPS in the July 20th issue of Research Reports. Available free to AIER subscribers or $2 for non-members.

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