Bond yield comparisons are seriously distorted by using consumer price index deflators.
- Measuring real bond yields using GDP deflators shows a radically different picture from using consumer price inflation indexes, the use of which can seriously distort investment decisions
- The GDP deflator measures general inflation across all domestically produced goods and services and not a basket of consumer goods
- The highest real (GDP deflated) yield recorded in the top economies was for France (4.6%). Using the “normal” CPI deflator the French government bonds yields were 0.4%.
interest rates are simply the difference between nominal yields and inflation,
but the price index used to measure inflation can have a significant distorting
impact on investment decisions. The most appropriate price index to use is the
GDP deflator, but the most frequently used in practice are consumer price
indexes. In March 2012, a report by PricewaterhouseCoopers to the UK’s
Financial Services Authority recommended using the GDP deflator instead of the
Retail Price Index for projected rates of return on a variety of asset classes. On the basis of
lower economic growth projections and the change in deflator the FSA
subsequently significantly downgraded its projected real rates of return due to
become mandatory in April 2014.
from the impact on the financial services industry the distortions arising from
the wrong choice of index can seriously impact upon differences between real
government borrowing costs and the burden on taxpayers. Even small differences between the CPI and the GDP deflator can
have a large impact on the real rate that a government is borrowing at compared
with the often consumer price indexed linked welfare payments it makes.
impetus to use consumer price indexes arises from governments who build them into
index-linked government securities which informs much market comment on the comparative
real yield on other bonds. In the US, for example, Treasury Inflation Protected
Bonds (TIPS) pay interest rates that are adjusted using the Consumer Price
Index (CPI) while in the UK index-linked gilts are based on changes in the
Retail Price Index, a measure of inflation based on a basket of consumer purchases
rather than an estimate of inflationary pressures across the economy.
are a number of key differences between the scope of the CPI and the GDP
deflator and in the methods by which they are calculated. The GDP deflator
measures inflation in the prices of all goods and services produced
domestically by the private and the public sectors. The CPI measures changes in
the cost of purchasing a fixed basket of consumer goods which includes both
domestically produced goods and services and imported products. The wider coverage of the GDP deflator makes it more
appropriate for use in calculating real government bond yields because it allows
a comparison of the real cost of finance with the level of government
expenditure in constant prices as a proportion of GDP. In addition, it measures
the real return to bond holders in terms of real national income generated and
not the real cost of purchasing a sample of consumer goods.
differences in calculating real government 10 year bond yields with the GDP deflator
rather than the CPI is illustrated by data for the ten largest economies in
Figure 1. In France, real government bond yields adjusted for general inflation
came first in providing high real returns. Ten year French Government bonds
provided domestic holders with a real return of 4.6% rather than the far
smaller 0.4% suggested by the use of the consumer price deflator. This is far
better than the real returns of 0.1% and 0.4% in Germany and the USA respectively,
while domestic holders of UK government debt experienced a poor negative real loss
In practice, the difference between the deflator and CPI for some
countries is often relatively small, but as the table shows for some countries using
2012 data to deflate current bond yields it was enough to turn a negative yield
to positive – (Germany and India) or to make a positive yield negative (Russia).
CPI remains the most common price index used in calculating real bond returns,
but it is highly recommended that investors insist on their advisors using the
GDP deflator for calculating historic and projected real returns. As noted
earlier this was one of the little noticed technical recommendations of a
report by PricewaterhouseCoopers to the UK’s Financial Services Authority in
April 2012 for projected rates of return.