Why the U.S. Treasury Should Issue More TIPS

Traders work at the Chicago Board of Trade in Chicago, Illinois Photograph by Daniel Acker/Bloomberg

Remember when a group of 23 conservative economists, hedge fund managers, and Republican strategists called on the Federal Reserve to discontinue quantitative easing in an open letter addressed to chairman Ben Bernanke in 2010? The petition highlighted that the “planned asset purchases risk currency debasement and inflation.”

Luckily, Bernanke and the other Fed governors ignored the petition. No matter which gauge you prefer, the message remains the same: Inflation is tame. Consumer price inflation for the 12 months ending in March 2013 ran at 1.5 percent. The personal consumption expenditure price index is up nearly 1 percent year-over-year. The Federal Reserve Bank of Cleveland’s model that combines information from a number of sources estimates that the inflation rate expected by the public over the next 10 years is 1.47 percent. Short-term, with so much slack in the labor market, it will take years before the U.S hits the kind of resource-straining growth that typically raises alarms on Wall Street. Longer-term, the potent combination of heightened global competition, rapid technological innovation, and ingrained central bank inflation-loathing will keep a lid on inflationary pressures, as with the experience of the past three decades.

That said, savers are right to worry about the risk of inflation in coming years. Uncertainty about the risk of future inflation is heightened by the federal government’s massive borrowings. A classic way for governments to lower the cost of debt payments without raising taxes is by embracing inflation. In other words, the risk of inflation has diminished in recent decades. It hasn’t disappeared.

No magic wand exists to eliminate the uncertainty. But policymakers can reassure long-term savers of their anti-inflation credentials with a change in the U.S. government’s debt management policy: Sell only inflation-indexed notes and bonds with a maturity of 5 years or more. The bulk of U.S. Treasury bonds offered by the government don’t protect against inflation, while the value of Treasury Inflation-Protected Securities is pegged to the U.S. consumer price index, providing a safeguard from the ravages of rising prices. TIPS currently make up about 10 percent of the U.S. Treasury note and bond markets. (The first TIPS were sold in 1997; the first I-bond, an inflation-indexed savings bond, was marketed a year later.) The time is opportune to make the shift because inflation is subdued. “The temptation five to 10 years from now to embrace inflation will be strong,” says Varadarajan Chari, an economist at the University of Minnesota. “We ought to have a lot of inflation-indexed securities out there.”

For savers, TIPS are as close to a riskless security anyone can buy. TIPS combine the high-quality of U.S. Treasuries with a built-in inflation hedge. Both the principal and the coupon are adjusted upward for inflation. For the Fed, TIPS are an invaluable signal for divining the market’s expectations about the future course of inflation. For the U.S. Treasury, TIPS can be a cheap source of funding.  For example, TIPS sold at a negative yield of 1.311 percent at the most recent auction of 5-year maturities. Investors are taking out an insurance policy against the risk that inflation turns out to be higher than expected. The negative yield is essentially the “insurance premium” for the protection from inflation. With all the uncertainty about future rates of inflation, there is “nothing irrational about investing some of one’s wealth in TIPS, at a negative real interest rate, in order to eliminate this uncertainty,” says Zvi Bodie, a finance professor at Boston University.

Of course, TIPS will cost the government more if inflation spirals higher. That’s okay, however, since the risk is an incentive for policymakers to keep a wary watch on the price level. Brief bouts of surging prices—inflation shocks—are inevitable with capitalism. Stuff happens. A TIPS-heavy financing strategy will reassure investors during these unnerving episodes that the underlying trend remains toward low inflation rates. “Recognition by the public that the government is accountable for higher inflation in the form of higher inflation payments to TIPS holders may help hold down inflation expectations and cause inflation expectations to be more firmly anchored, that is, less responsive to inflation shocks,” write economists William Dudley, Jennifer Roush, and Michelle Steinberg Ezer in a research report (PDF) for the Federal Reserve Bank of New York.

The world’s first-known inflation-indexed bonds were issued by Massachusetts in 1780, according to Robert Shiller, an economist at Yale University. The “depreciation notes” were indexed to the price of four commodities. (PDF) They were issued to soldiers during the Revolutionary War, a time of rapid inflation. Inflation-indexed bonds largely stayed on the fringes of global finance until the 1990s, when the governments of a number of major industrial countries embraced them, including the U.S. Inflation-indexed securities aren’t an inflation-slaying elixir. No, they’re an insurance policy, a safe haven for investors, and a force for keeping inflation down. Seems like a good policy to buy.

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