Inflation-indexed bonds (TIPS in particular, the acronym for Treasury Inflation-Protected securities) seem an undervalued asset. Using the conventional break-even approach, TIPs have lately implied an implausibly low long-term US inflation rate: 1% at the 10-year horizon and less than zero at the 5-year horizon.    Is the explanation that people fear deflation?    It is hard to see that we could have negative inflation for many years.   I suspect the standard calculation of the implicit TIPS premium for expected inflation doesn’t even take into account the asymmetric form of their indexation, which makes them something of a one-way bet:   When the security matures, the U.S. Treasury pays the original or adjusted principal, whichever is greater.   Surely the market is not correctly pricing TIPS.   One implication is that they cannot be relied upon as an indicator of expected inflation. Another is that we should all buy them.Of course I am not the first one to have noticed this:   quite a few others have pointed it out in recent weeks and months.    Indeed the prices of TIPs have begun to recover a bit since the beginning of the year.   But I think they have further to go.Perhaps the Fed should buy TIPs, alongside all the other assets it is buying. Or the Treasury should swap them for conventional long-term Treasury bonds, now that investors are pushing the price of the latter down in response to huge increases in supply (i.e., are finally demanding higher returns on long-term Treasuries).   Either strategy should help a bit improve the country’s endangered long-term fiscal situation.

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Originally published at Jeff Frankel’s Weblog and reproduced here with the author’s permission.

2556752 Responseshttp%3A%2F%2Fwww.economonitor.com%2Fblog%2F2009%2F02%2Ftips-tips%2FTIPS+tips2009-02-22+06%3A21%3A25Jeffrey+Frankelhttp%3A%2F%2Fwww.economonitor.com%2Fblog%2F2009%2F02%2Ftips-tips%2F to “TIPS tips”

Michael Rogaw • February 23rd, 2009 at 2:37 am

Prof. Frankel, TIPS may indeed be mispriced and a reasonable investment. However, I’d appreciate your thoughts on the following: (1) Whenever I hear the comparison with bank CDs and money market funds, I get nervous. A 10 or 20-year TIP has the same exposure to interest rate risk as a 10 or 20-year T-note. There is an assumption that inflation rates and treasury rates will move in tandem. However, it is easy to imagine that interest rates can become decoupled from inflation. If the demand for long term treasury notes is reduced because of high treasury issuance, treasury interest rates could rise dramatically even in the face of deflation, causing TIPS to be hit with a double whammy.

mangy cat • February 23rd, 2009 at 8:26 am

“Perhaps the Fed should buy TIPs, alongside all the other assets it is buying”wouldn’t that mean that the fed explicitly acknowledges it intends to default on its price stability mandate?