Assumptions make a fool out of you

Yesterday I dug into some economic source data for the first time in a long time. The initial impetus came from the need to revisit the post where I predicted what the nominal return on a 5 year treasury bond would be in a year’s time. Since the year was up last week, I figured it was time to take my medicine.

I have not been following economic stuff very closely this year. But I have kept enough of an eye on things to know that my prediction did not even come close to being true. For those that did not remember, my prediction was that the nominal return for 5 year treasuries would be 6.5%. Yesterday, 5 year treasuries had nominal rate of 2.36%. As you see, my prediction could not have been more wrong.

I wanted to write a post exploring where I went wrong. It would not have bothered me if I had not been exactly right. After all, I had admitted in my original post that my prediction was absurdly precise. But I had really expected that I would at least get the direction of the move in nominal prices right.

But what really bothered me (at least on an intellectual level) was the real return on the federal debt. If you go back and read my post, you will see that my whole argument center around proving that the Federal government was going to have to offer a 3% real return to get anyone to buy its bonds. In my argument, I had just assumed that inflation rate would hold more or less constant to arrive at my nominal prediction.

I knew that this was not a very defensible assumption (which is why my original post never really tries to justified the assumed inflation rate). But I figured that any likely fluctuations in the inflation rate would not detract from an obvious rise in real rates and so I could get away with not devoting much thought to the inflation rate.

Now I have not been following the inflation rate lately. But I no matter what it was at, I figured it had to make my real return figures look real bad. After all, to get the real rate of return you have to subtract the inflation rate from the rate of return. And it would not take much inflation at all to make 2.36% a lot less then 3%. It already had a pretty good start in that direction. And that would gut the core of the argument that I had tried to make. So I was sure my argument was going to look like total bunk in retrospect.

As it turns out, the rolling 12 month figure for CPI was -1.5. Since that is a negative number it has to be added to nominal rate of return to get the real rate of return. That would put the real rate of return at 3.86%.

I should have made my prediction in real terms and not assumed a constant rate of inflation.

One Response to “Assumptions make a fool out of you”

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