Can TIPS Help Identify Long-Term Inflation Expectations?

Investors and policymakers have long hoped that Treasury Inflation Protected Securities (TIPS) would provide an accurate measure of long-term market inflation expectations. To make informed decisions and to ensure that inflation does not erode the purchasing power of their assets, investors need to assess the rate of inflation expected by other market participants. Having an accurate measure of market inflation expectations can also help policymakers assess their effectiveness in controlling long-term inflation, as well as their credibility among market participants. Until recently, however, the only sources of information about long-term inflation expectations were surveys and the term structure of interest rates, neither of which were considered highly reliable. With the introduction of TIPS in 1997, it was hoped that a new measure of market inflation expectations—the difference in yields between conventional Treasuries and TIPS—would become available. The yield difference between conventional Treasuries and TIPS may provide an accurate measure of market inflation expectations because inflation has very different effects on the returns to the two kinds of securities. The yield on a conventional Treasury must compensate the buyer for any expected erosion in purchasing power due to future inflation. In contrast, the buyer of an inflation protected Treasury need not worry about future inflation because the principal and interest payments are both