Academic journal article Federal Reserve Bank of New York Economic Policy Review

Treasury Inflation-Indexed Debt: A Review of the U.S. Experience

Academic journal article Federal Reserve Bank of New York Economic Policy Review

Treasury Inflation-Indexed Debt: A Review of the U.S. Experience

Article excerpt

* Treasury inflation-indexed securities (TIIS) have yet to live up to one of their primary goals: reducing the U.S. Treasury's expected financing costs.

* Since 1997, yields on TIIS have been surprisingly high relative to yields on comparable nominal Treasury securities, with the spread between yields falling, on average, well below survey measures of long-run inflation expectations.

* This study attributes this "valuation puzzle" to several factors: investor difficulty adjusting to a new asset class, divergent supply trends between TIIS and nominal Treasuries, and the lower liquidity of TIIS. In addition, investors may have had a benign outlook for inflation and inflation risks.

* More recently, the liquidity and breadth of investor participation in the TIIS market have increased notably, and the valuation of these securities appears to have improved.

l. INTRODUCTION

In January 1997, the U.S. Treasury began issuing Treasury inflation-indexed securities (TIIS)--debt securities with coupon and principal payments that adjust in line with a measure of consumer prices. Through 2003, the Treasury had issued $172 billion of these securities, with maturity dates ranging from 2002 to 2032. By the end of 2003, the amount of TIIS outstanding (including inflation accrual) totaled approximately $176 billion, or nearly 7 percent of all outstanding Treasury notes and bonds.

Inflation-indexed debt held the promise of providing benefits to both investors and the Treasury. Investors could benefit, it was argued, from access to a new type of asset that reduces the risks associated with inflation. By purchasing inflation-indexed securities, they could lock in a real rate of return--measured in terms of the amounts of goods and services that can be purchased--over the maturity of the security, thereby protecting themselves against the possibility that an unexpected rise in inflation would erode the real return on a nominal debt security. (1) Moreover, the Treasury's willingness to issue TIIS could provide a benchmark that would spur private issuance of inflation-indexed securities.

The Treasury would also benefit, some argued, because the issuance of inflation-indexed debt would likely reduce its financing costs. The rationale was that investors typically demand a higher return on nominal debt securities to compensate for the risks associated with future inflation. By issuing inflation-indexed debt, the Treasury would eliminate that risk for investors and therefore avoid having to pay this "inflation risk premium," which would also lower its financing costs. (2)

In addition, some argued that issuing indexed debt would offer ancillary benefits by providing policymakers and market participants with a useful reading of real interest rates. In that case, comparing the yields on TIIS with those on nominal securities would provide a measure of the amount of compensation that investors demand to offset future inflation and the associated risks--a potentially useful gauge for monetary policymakers.

This article describes the U.S. experience with inflation-indexed debt, including the evolution of activity in the TIIS market since its inception and the valuation of those securities relative to nominal Treasury issues. We show that despite the potential appeal of TIIS, their yields have been surprisingly high relative to those on comparable nominal Treasury securities. Indeed, the spread between ten-year yields on nominal securities and TIIS has, on average, fallen about 50 basis points below the long-run inflation expectations reported in the Survey of Professional Forecasters, conducted by the Federal Reserve Bank of Philadelphia. We analyze several explanations for this "valuation puzzle" as well as offer evidence that bears on those explanations.

One possibility is that the low relative valuation of TIIS has reflected investor difficulty adjusting to a new asset class. …

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