Liquidity in the Treasury Inflation-Protected Securities market has grown substantially over the last decade after a rough initial start, which even resulted in an advisory body recommending that it be closed in 2001. Part of the return on these investments is attributable to the uncertainty of future inflation, or the inflation risk premium. The authors show that the inflation risk premium has decreased and become less volatile during the 2000s.
What’s Inside?
Using an eight-year sample from the early 2000s, the authors show that the inflation risk premium was negative in the first half of the sample but positive in the second half. The negative first half may have been caused by the deflation scare around 2002–2003. Overall, the variation in inflation estimates decreased during the sample period, implying that the market views the U.S. Fed’s monetary policy as credible. The authors’ estimation of the inflation premium is lower compared with that of previous research, especially for shorter maturities, which may be caused by using direct market data instead of survey data.
How Is This Research Useful to Practitioners?
The authors’ empirical results highlight that the average real yield is lower than the Treasury Inflation-Protected Securities (TIPS) yield partly because of the indexation lag. Furthermore, they show that TIPS yields are higher in the first half of the decade and less volatile than in the second half of the decade. They determine that the vector autoregression provides the best estimate for forecasting expected inflation. They also illustrate that the inflation risk premium increases with longer maturities.
For calculating expected inflation, the authors consider three alternatives. First, they use the historical inflation based on the U.S. Consumer Price Index (CPI) inflation, which is an unconditional average of the historical inflation rate. In the second option, they use a first order vector autoregression that uses variables for real activity (e.g., unemployment rate) and inflation (e.g., year-to-year inflation rates based on CPI). For the third alternative, the authors gather forecasted inflation from surveys and show that both the realized CPI and the expected inflation are higher than the breakeven inflation rate.
The authors estimate the liquidity premium in the TIPS market using several measures. First, they use the noise measurement between the observed nominal yields and the implied yields, which indicates a stable liquid market between 2005 and 2008. Second, they use the turnover ratio, which shows that TIPS liquidity has been improving during the sample period. They also consider the on-the-run and off-the-run Treasury yields. All three variables have low correlations and thus explain market liquidity. The authors conclude that their inflation risk premiums are low compared with those of previous research but note that because of different sampling periods and the low inflation environment, a direct comparison is not straightforward.
Inflation risk is an important risk for defined benefit pension schemes and inflation-linked insurance products, so practitioners working in these fields might find the results of this research useful.
How Did the Authors Conduct This Research?
Historical research has shown large differences in the estimation of the inflation risk premium, and evidence for both a negative and positive inflation risk premium exists. But there is no agreement about how large it should be.
TIPS are bonds for which both the coupon payments and principal payments are linked to an official price level (e.g., CPI). These securities are almost risk free, except for the time lag between the official inflation numbers and the payments for the inflation adjustment. Just after the economic crisis of 2009, the demand for TIPS increased substantially, and TIPS is now the largest inflation-linked securities market.
The authors look into the elements of TIPS returns to estimate the inflation breakdown. They use a sample period from January 2000 to September 2008. They also use smoothed nominal government zero coupon bond data for terms of 5, 7, and 10 years. The difference between nominal government bonds and TIPS is referred to as the breakeven inflation rate, which consists of expected and unexpected inflation. The latter provides a premium for uncertainty and is referred to as the inflation risk premium. Unfortunately, this premium is not directly observable and the relatively young TIPS market makes analysis challenging.
TIPS prices are adjusted for the three-month time lag and for the lower liquidity of the TIPS market compared with Treasuries.
Abstractor’s Viewpoint
In times of low interest rates, deflation fears become more relevant for institutional and individual investors. Thus, instruments providing inflation protection like TIPS become more interesting to invest in. Because TIPS offer inflation (not deflation) protection, it can be said that the level of interest is linked to fears of inflation (inflation expectations) derived from global central bank monetary policy. The authors clearly outline the several inflation components and how the inflation premium can be modeled. They also highlight the difference in the inflation environment in the early and late 2000s and note that the liquidity of the TIPS market has increased during the 2000s. Because inflation affects a wide variety of investors, this is interesting research for a wide range of practitioners.