Inflation Risk and TIPS

TIPS, which stands for Treasury Inflation Protected Securities, offer insurance against inflation risk. Inflation reduces the real return from nominal coupon payments, that is, the purchasing power of this stream of cash flows. TIPS compensate the bondholder by adjusting the coupon for realized inflation. In principle, the spread between nominal Treasuries and TIPS should provide a noisy gauge of market inflation expectations. The noise reflects a liquidity premium as well as an unexpected inflation premium. TIPS investors require the liquidity premium because the TIPS market is relatively small compared to the conventional Treasury market. The unexpected inflation premium arises because TIPS yields are adjusted using actual inflation while conventional Treasury yields reflect expected inflation. The spread in nominal Treasuries over TIPS is therefore a rough forecast of inflation expectations. Figure 2.2 (see TIPS in Chapter 2 Examples.xlsx) shows nominal Treasury yields over TIPS for the period February 2004 to January 2006.

Figure 2.2 Breakeven Rate: Nominal over TIPS

These spreads represent bond market participants’ inflation expectations for different horizons (they understate inflation expectations because TIPS also carry a liquidity premium). For example, in 2004, these expectations were converging over horizons 2 to 20 years to about 2.7 percent (see the table in the TIPS spreadsheet for specific values) at the end of 2004 with long-term expected inflation (embedded in 20-year TIPS) still close to 3 percent and short-term expected inflation as embodied by the two-year TIPS around 2.5 percent. There were two distinct jumps in the two-year TIPS in 2005 coinciding with the Fed's response to its own perceptions of inflationary pressures and its tightening of short-term yields.