A TIPS Scorecard: Are They Accomplishing Their Objectives?

Treasury Inflation-Protected Securities were developed to provide (1) consumers with assets that permit hedging against real interest rate risk, (2) nominal contract holders a means of hedging against inflation risk, and (3) everyone with an indicator of the term structure of expected inflation. This article evaluates progress toward these objectives.In 1997, the U.S. Treasury introduced Treasury Inflation-Protected Securities (TIPS) to achieve three major policy objectives: (1) to provide consumers with a class of assets that enables them to hedge against real interest rate risk, (2) to provide holders of nominal contracts with a way to hedge against inflation risk, and (3) to provide everyone with a reliable indicator of the term structure of expected inflation. We examined the extent to which these objectives have been achieved and sought to identify ways whereby they can be better achieved in the future.The viability of the TIPS market hinges on whether TIPS provide an effective hedge for most investors against unexpected changes in the real rate of interest that could result from unexpected fluctuations in inflation. Inflation-protected indexed bonds are designed to deliver, to the extent possible, a certain pretax real return to maturity. In the United States, these bonds are indexed to the Consumer Price Index (CPI) for all urban consumers (CPI-U). We focused on two important factors that may limit the ability of this class of securities to offer investors a complete hedge against unexpected changes in the real rate: (1) the possibility that the CPI may not be an appropriate index for all investors and (2) the potential for technical revisions to the measurement of the CPI, such as those recommended by the Boskin Commission just before the initial auctioning of TIPS in January 1997. Either or both of these factors could engender inflation basis risk. We did not address another widely known limiting factor: the fact that the CPI is not continuously measured and published, with the result that the indexation of TIPS’ nominal cash flows occurs with some lag.During the summer of 2008, a spate of popular press articles claimed that the existing methodology of computing the CPI underestimates true inflation. Some authors even asserted that the measure is subject to political influence and has been biased downward over time via methodological changes during several presidential regimes. Because these concerns speak to uncertainties regarding the ability of TIPS to hedge effectively against unexpected changes in the real rate, a few of these articles, not surprisingly, concluded that for many investors, TIPS are not, in fact, good hedges against inflation. We evaluated these criticisms and, to the extent that they are valid, assessed their implications for the efficacy of TIPS as a hedge against unexpected changes in the real rate of interest.We explained the design of TIPS, their tax implications for investors, the demographics of TIPS holders, and other considerations relating to whether TIPS should yield measures of breakeven inflation rates comparable with survey measures of consumers’ inflation expectations. We used both theoretical and empirical analysis to evaluate criticisms of the CPI as an inflation benchmark for adjusting the return on TIPS. We discussed whether the potential mismeasurement of the CPI is relevant to the efficacy of TIPS as a hedging instrument to guarantee the real return, whether the CPI is a good measure for everyone, and whether there might be more appropriate measures for certain heterogeneous groups, as well as the costs and benefits of issuing such securities. We then demonstrated the efficacy of TIPS as a hedge against various ex ante and ex post inflation measures and their efficacy as a short-term versus a long-term hedge.We conclude that the TIPS market provides a good hedge against inflation risk, and from a cost/benefit perspective, little is to be gained from indexing to other inflation measures, be they broader, such as the GDP deflator, or narrower, such as regional inflation measures or the CPI-E (for the elderly). As the proportion of retirees who have defined benefit pensions continues to decrease, the need for individuals to manage lump-sum accounts to provide a steady stream of real income during their retirement becomes more difficult. A “ladder” of TIPS with maturities linked to the dates when the money will be needed for expenses is a safe investment well suited to retirees and those approaching retirement. TIPS have the potential to be the backbone asset underlying inflation-indexed annuities, but the maximum duration of TIPS would need to be extended in order to facilitate such annuities.Note: The views expressed in this article are solely those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Boston or the Federal Reserve System.