The Microstructure of the TIPS Market

he introduction of Treasury inflation-protected securities (TIPS) in the United States in 1997 offered multiple potential benefits. First, the development was intended to offer investors a security that would enable them to hedge inflation. Second, by taking on the risk of inflation, the U.S. Treasury Department would not have to pay an inflation risk premium on its securities, thereby lowering its expected borrowing costs.1 And third, the securities would provide a market-based measure of inflation expectations. It would be possible to gauge market expectations of inflation by comparing the yields on nominal Treasury securities with yields on inflation-protected securities of comparable maturities. These potential benefits have not been fully realized, mainly because TIPS lack market liquidity compared with nominal securities. This lack of liquidity is thought to result in TIPS yields having a liquidity premium relative to nominal securities, which offsets the inflation risk premium.3 Similarly, the presence of a liquidity premium in TIPS yields complicates inferences of inflation expectations, particularly if the