Wednesday, March 09, 2005


When TIPS (Treasury Inflation-Protected Securities) were introduced in 1997, investors were offered a new option, whereby they could hedge inflation risk. Analysts were, at the same time, provided with a simple way to measure anticipated inflation: simply compare yields on equal-maturity Treasuries, TIPS vs conventional, and observe the extra compensation that investors want in order to to forego the hedge.

Yet, it is never that simple. The FRB of Cleveland's Nov 2004 Economic Commentary features "Expected Inflation and TIPS" by Charles T. Carlstrom and Timothy S. Fuerst. The essay includes evidence of that inflationary expectations (as measured by University of Michigan and FRB of Philadelphia surveys) and the gap between equal-maturity yields have not matched. It also cites plausible theoretical explanations. TIPS buyers not only are insured against whatever inflation actually comes to pass but they are also immune from the risk of making bad guesses. Hence, the yield gap overstates expected inflation. Another reason to be wary of the yield gaps is that, to date, TIPS are somewhat less liquid than conventional Treasuries.

TIPS are a fine innovation but the investor's life is complex. Something new and something old.