Assessing the term structure of expected inflation using treasury inflation—protected securities: near real-time measures for those who need quick estimates

Business Economics, Jan, 2003 by Albert E. DePrince, Jr.

With the 1997 introduction of Treasury Inflation-Protected Securities, or TIPS, the calculation of market-based inflation expectations became possible. With the passage of time and the issuance of successive securities, it also became possible to estimate the term structure of expected inflation. That is, how do expectations differ over alternative forecast horizons? This paper estimates and assesses such a term structure. The process is fraught with problems stemming from various factors that affect the yields of inflation-protected and conventional securities used to calculate the expected inflation measures. Even so, the study finds that the approach provides at least crude estimates of expected inflation over various forecast horizons, and those estimates represent near real-time measures for those who must make ongoing decisions based on expected inflation. Equally important, this paper provides the reader with an understanding of readily available, market-based forecasts of inflation.

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Financial markets provide a wide range of market-based forecasts. Forward interest rates can be derived from spot interest rates, and interest rate futures provide market-based views on expected interest rates and foreign exchange rates. Swap contracts also contain market-based expectations. However, no market-based measures dealt directly with expected inflation until the appearance of Treasury Inflation-Protected Securities (TIPS). Instead, market-wide forecasts could be obtained only from forecast surveys or individual analytic efforts.

This report analyzes the term-structure characteristics of inflation forecasts derived from TIPS from February 1997 to September 2002. It begins with a background on TIPS, followed by a brief description of the concept of the term structure of expected inflation. A model of the yields on the TIPS and conventional Treasury securities is next developed. The process used to generate the term structure of expected inflation from these two classes of securities is reported; and the term structure characteristics are evaluated, and similarities to and differences from survey results are noted. The paper ends with a summary of the key findings.

Background on Treasury Inflation-Protected Securities

On January 29, 1997, the U.S. Treasury issued its first TIPS. These securities were modeled on the government of Canada's Real Return Bonds, and the United States joined eleven current issuers of inflation-protected securities (BOE, 1996), including Australia, Canada, Denmark, Iceland, Ireland, Israel, Mexico, New Zealand, Sweden, Poland, and the United Kingdom.

The U.S. TIPS apply a fixed real coupon rate to a principal (not the coupon rate) that is indexed for inflation and adjusted daily. Specifically, a daily adjustment index is generated through a linear interpolation of adjacent Consumer Price Index values, and this interpolated index is applied each day to the principal. Since there is a two-month lag between the current month's value of the inflation-adjusted principal and the latest CPI used in the indexation, one could argue that indexation is a bit incomplete.

The semi-annual coupon payment is the product of a stated real coupon rate and the inflation-accreted principal. As a result, the nominal coupon payments will rise month by month if the accreted principal rises, but there is no change in the real coupon rate. The accreted principal is not paid with the coupons, but accrues and is paid at maturity. The coupon payments and principal accrued between coupon dates are considered currently taxable income, even though the accrued principal is not paid until maturity. By October 31, 2002, the outstanding inflation-protected notes and bonds totaled $146.4 billion, including $11.0 billion of accrued principal.

The Treasury's auction cycle for TIPS has evolved over the years. At this time, the benchmark inflation-protected security is the ten-year note. Over the six-year history of the TIPS, a new ten-year inflation-protected note was issued each January. Beginning in 1998, and continuing through 2002, this note was "reopened" (by auctioning more securities with the same maturity and the same real-coupon as the January issue) in the following July. Beginning in 2002, however, the Treasury began to issue a new ten-year inflation-protected note in July, rather than reopening the previous January's issue.

The Treasury auctioned only one five-year inflation-protected note (July 1997), due to lack of investor interest in that maturity. The Treasury also set an annual auction cycle for thirty-year inflation-protected bonds, with the first issued in April 1998. But auctions of inflation-protected bonds were suspended, after only two were issued, as the developing federal budget surplus forced the Treasury to free auction space for conventional thirty-year bonds. At the time, the Treasury also decided that liquidity of TIPS could be best enhanced by focusing all new TIPS auctions at the ten-year maturity. However, in April 2002, the Treasury reinstituted an annual auction of thirty-year inflation-protected bonds as the re-emergence of budget deficits expanded the Treasury's cash needs; it is likely that thirty-year inflation-protected bonds will be auctioned in subsequent years.