Turning first to the issue of measuring the impact of TIPS issuance on the government’s funding costs, this could be done simply by comparing the ex-post costs of a program of TIPS issuance to the costs of a comparable program of nominal Treasury issuance. Studies 1 of this sort have typically shown that TIPS issuance has resulted in a higher net cost to the Treasury. Unfortunately, although this methodology is attractive in its simplicity, it has some flaws that undercut its usefulness in reaching conclusions about the attractiveness of the TIPS program. The problem with an ex-post analysis is that it depends critically upon the performance of inflation over the period in question. If inflation turns out to have been meaningfully different than what was expected at the time of TIPS issuance, then this difference – the so-called “inflation surprise” – can be important in affecting the relative costs of TIPS versus nominal Treasury issuance. If inflation turns out to be higher than expected, then TIPS issuance will likely look to have been more expensive than nominal Treasury issuance. If inflation turns out lower, an ex-post analysis will likely show a savings from the TIPS program. Over the long run – and I mean the very long run – there should be roughly as many downward surprises in inflation performance as upward surprises. But within any relatively short period, such as the last decade, this certainly does not need to be the case.
The public’s recognition of this incentive may help hold down inflation expectations and cause inflation expectations to be more firmly anchored. In addition, TIPS may give the Treasury access to a broader investor base, which also may reduce the Treasury’s overall borrowing costs. The comparison between the prevailing interest rates on TIPS versus nominal Treasuries provides insight into the relative costs associated with issuing a marginal dollar of debt. But just as important is whether TIPS issuance, by displacing nominal Treasury issuance, reduces the level of interest rates that the Treasury pays on its nominal issuances. This would occur if TIPS were not perfect substitutes for nominal Treasury securities and if the demand for nominal Treasuries were downward sloping – that is, not completely elastic. The first condition almost certainly holds given the different attributes of TIPS versus nominal Treasuries. If they were perfect substitutes, then there would not be a liquidity premium for nominal Treasuries relative to TIPS. The second condition seems likely to hold since numerous studies have found that an increase in the net amount of Treasury borrowing leads to higher expected borrowing costs for the Treasury. How big might this effect be? That’s difficult to estimate. A few studies 6 have found that an increase in supply in a particular segment of the Treasury yield curve has contributed to a rise in yields.