TIPS Can Help Improve the Fiscal Situation

Includes: IPE, TIP
by: Jeffrey Frankel

Everyone asks for tips: Where can I put my money? Stocks or bonds have done very badly over the last year, needless to say, and one cannot be confident that they have hit bottom. Should one just leave everything in banks and money market funds? Surely there must be something else worth buying?

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 to improve the country’s endangered long-term fiscal situation.