Inflation-indexed bonds ; Government securities

William G. Dewald

English

Research Papers in Economics

July 1998
MonetaryTrends
Did You Know That the
Fed Holds TIPS?
The Treasury began issuing inflation-indexed notes
in January 1997.  These Treasury Inflation-Protected
Securities (TIPS) provide a market-based measure of
inflationary expectations.1 Investors value TIPS as an
inflation hedge.  The Treasury values them as a
source of funds that can reduce interest outlays when
the inflation premium in non-indexed securities is
higher than actual inflation over the maturity of the
security.  The Fed values them as providing another
measure of expected inflation.  
A total of $47 billion of the new notes have been
issued, with 5-, 10-, and, most recently, a 30-year
maturity.  On April 15, the Treasury issued $8 billion
of the latter, which can be stripped to create inflation-
indexed zero-coupon derivatives with maturities up to
30 years.  Even the Fed has accumulated some TIPS.
As of April 30, 1998, it held $2.45 billion of infla-
tion-indexed U.S. government securities valued at
original face amount.  In addition the Fed had
received $27 million of compensation that adjusts for
the effects of inflation on the principal of these secu-
rities.  Fed holdings represent less than 5 percent of
TIPS held by the public and a minuscule fraction of
the Fed￿s roughly $450 billion portfolio of govern-
ment securities holdings.
Future inflation will determine whether the returns
on the inflation-indexed securities turn out to be higher
than returns on non-indexed nominal notes of compa-
rable maturity.  As shown in charts on page 11, 10-year
indexed Treasury notes in mid-June were selling for an
inflation-adjusted return of about 3.7 percent compared
with about 5.5 percent on a non-indexed note of the
same maturity.  The 3.7 percent real return to investors
incorporates expectations of future real rates and
prospective tax liabilities because the compensation for
inflation paid to holders of TIPS is taxable.  
In acquiring inflation-indexed securities, the Fed
has purchased some insurance against the effect of
inflation on its earnings.  Such protection is reason-
able for private investors who perceive future infla-
tion risks, but what about for a central bank?  Fed
purchases of indexed bonds may have helped estab-
lish this fledgling market, but do its holdings of infla-
tion-indexed securities interfere with their usefulness
in providing a market measure of inflation expecta-
tions and inflation risks?  Also, does the Fed lose
inflation credibility by holding such securities?  The
answer to such questions is probably not.
One reason is that any extra earnings the Fed gets
by holding TIPS are transferred to the Treasury.
Another reason is that the Fed does not actively trade
any longer-term issue including the new inflation-pro-
tected securities.  Therefore, its holdings of longer-
term issues simply represent claims on the federal
government against which the Fed has issued curren-
cy and bank reserves, the total of which comprise the
monetary base.  Even though the Fed holds a lot of
long-term government debt and now some inflation-
indexed debt too, as long as such securities are not
actively traded, Fed holdings of such securities would
not exert a direct influence on the price, quantity, or
composition of federal debt held by the public.  By
implication, Fed holdings of TIPS need not distort
information about expected inflation coming from the
market yields of these inflation-protected securities.
￿William G. Dewald
1 See William R. Emmons, ￿Indexed Bonds and Falling Inflation
Expectations,￿ Monetary Trends, August 1997.
Views expressed do not necessarily reflect official positions of the Federal Reserve System.

Did you know that the Fed holds TIPS?

http://research.stlouisfed.org/publications/mt/19980701/cover.pdf

Did you know that the Fed holds TIPS?

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics