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• W1528398222 abstract "Investors and policymakers have long hoped that Treasury Inflation Protected Securities (TIPS) would provide an accurate measure of long-term market inflation expectations. To make informed decisions and to ensure that inflation does not erode the purchasing power of their assets, investors need to assess the rate of inflation expected by other market participants. Having an accurate measure of market inflation expectations can also help policymakers assess their effectiveness in controlling long-term inflation, as well as their credibility among market participants. Until recently, however, the only sources of information about long-term inflation expectations were surveys and the term structure of interest rates, neither of which were considered highly reliable. With the introduction of TIPS in 1997, it was hoped that a new measure of market inflation expectations-the difference in yields between conventional Treasuries and TIPS-would become available. The yield difference between conventional Treasuries and TIPS may provide an accurate measure of market inflation expectations because inflation has very different effects on the returns to the two kinds of securities. The yield on a conventional Treasury must compensate the buyer for any expected erosion in purchasing power due to future inflation. In contrast, the buyer of an inflation protected Treasury need not worry about future inflation because the principal and interest payments are both indexed to inflation. As a result, the yield difference between conventional and inflation protected Treasuries of given maturity should reveal the rate of future inflation expected by market participants. Not everyone agrees, however, that the yield difference provides an accurate measure of expected inflation. Skeptics point out that the yield difference may depend on other factors, such as the liquidity difference between the two kinds of Treasuries, making it difficult to extract information about market inflation expectations. This article examines the empirical evidence on the behavior of the yield difference and the liquidity of the TIPS market. The article finds that the yield difference has not provided a good measure of market inflation expectations because of the large and variable liquidity premium on TIPS. Still, the yield difference may become a better measure of market inflation expectations as liquidity conditions in the two kinds of Treasury markets move closer in the future. The first section of the article explains why the yield difference between conventional Treasuries and TIPS might provide a good measure of market inflation expectations. The second section examines the actual behavior of the yield difference since TIPS were introduced and points out that the yield difference appears to be influenced by factors other than market inflation expectations. The third section investigates the role of market liquidity and concludes that the difference in liquidity between the two types of Treasuries has kept the yield difference from becoming a good measure of expected inflation. The fourth section suggests that the yield difference between conventional and inflation protected Treasuries may approximate market inflation expectations better in the future. I. WHAT ARE YIELD SPREADS AND MIGHT THEY TRACK MARKET INFLATION EXPECTATIONS? As TIPS are relatively new to many investors, this section briefly describes their main features. The section then examines the different components of the yield difference, or spread, between conventional and inflation protected Treasuries. The section shows that the expected rate of future inflation is the main component of the yield spread. The section also shows, however, that other components, such as the inflation risk premium and the liquidity premium may also be important, complicating the task of extracting information about market inflation expectations. What are TIPS? Since 1997, the U. …" @default.
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• W1528398222 title "Can TIPS Help Identify Long-Term Inflation Expectations?" @default.
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