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.

The preferred habitat hypothesis provides more flexibility. As with the liquidity premium hypothesis, it attributes the yield curve's shape to a term premium. However, the term premium need not rise with maturity but is adjusted by supply and demand pressures at each maturity segment. If the supply of securities at a given maturity is high, the term premium would be boosted and the market yield high and vice versa. The preferred habitat hypothesis effectively divides the term premium into two parts: a conventional maturity risk premium that rises with an asset's maturity, and a premium capturing relative supply and demand conditions at different maturities. The latter would best be termed a supply premium.

Taking into account the supply premium, the yield on a Treasury security with a maturity of m is:

* the real risk-free rate

* plus the maturity risk premium for an investment horizon of m periods

* plus the inflation premium for an investment horizon of m periods

* plus the inflation risk premium for a horizon of m periods

* plus the "supply premium" in the Treasury security market for Treasury securities with a maturity of m months.

Next, the composition of the yield on the TIPS reflects the same factors that influence the conventional yield except for the fact that there are no inflation or inflation risk premiums and probably no supply premium. However, because of their thin market, these securities may not have the same liquidity as conventional Treasury securities (Shen and Corning, 2001). The yield on an inflation-protected security at a maturity m at a given time may thus be denoted by the sum of:

* the real risk-free rate

* the maturity risk premium for an investment horizon of m periods

* the liquidity premium for a inflation-protected security with an investment horizon of m periods

One view is that the difference between the two securities of a maturity of m months approximates the inflation rate expected over a horizon of m months. This difference is equal to:

* the inflation premium

* plus the inflation risk premium for a horizon of m periods

* plus the "supply premium" in the Treasury security market for Treasury securities with a maturity of m months

* less the liquidity premium for the inflation-protected security of the same maturity of m months.

As can be seen, this assumes that the maturity risk premium is the same for both securities. This is consistent with the coverage in most finance textbooks, where the premium depends only on maturity and not on the type of asset held. At the same time, however, the presence of the inflation risk premium, the Treasury supply premium, and the TIPS liquidity premium may corrupt the use of the spread as an estimate of expected inflation. (4) If the premiums were relatively fixed, they would not pose a serious problem. However, if they gyrated, so would the estimate of expected inflation. At best, the spread could be considered an "approximate" measure of expected inflation for a horizon of m periods. This is potentially a serious drawback. A study of U.K. gilts indicated that the spread between conventional and inflation-protected guts is not a particularly good harbinger of future U.K. inflation (de Kock, 1991).