The Fed’s TIPSy Portfolio & Inflation Expectations
[E]xpectations for annual increases in the consumer-price index over the next decade—derived from the difference between nominal and inflation-protected Treasury yields—climbed above 2% this week for the first time since 2018.
— Wall Street Journal, January 6, 2021
Treasury Inflation-Protected Securities (TIPS) occupy a relatively obscure corner of the bond market, which has attracted unusual attention lately. TIPS are a category of U.S. Treasury bond designed, as their name would suggest, to provide protection against inflation. To quote an explanation given by the Treasury:
The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater.
TIPS pay interest twice a year, at a fixed rate. The rate is applied to the adjusted principal; so, like the principal, interest payments rise with inflation and fall with deflation.
The difference between the yield on TIPS and the yield on regular Treasury bonds referred to in the Journal article is the “breakeven rate,” which represents financial markets’ expectations of future inflation. To take a simple example, if ten-year Treasuries are yielding, say, 3 percent, and the ten-year TIPS is at 1 percent, then the markets are expecting annualized inflation over that period of 2 percent. Since TIPS buyers are concerned about inflation protection, they are thinking long-term and TIPS trading volumes are low, just 3 percent of the volume of regular Treasury bonds.
Due to low volume and thus limited capacity to absorb additional TIPS, the Treasury has restrained new TIPS issues compared with regular bond issues as it finances recent enormous federal borrowing. Since the pandemic, TIPS have fallen sharply as a percentage of Treasuries issued. At the same time, a voracious buyer of TIPS has (as pointed out by market analyst Danielle Booth) emerged, the Federal Reserve. The chart below illustrates that, as Treasury has limited TIPS issuance, the Fed has gobbled up the market, increasing its holdings dramatically.
There is a predictable effect of large buying in a limited, illiquid market: Prices rise. For TIPS and other bonds, rising prices mean lower yields, which currently are negative for TIPS. Since the breakeven inflation indicator is the regular bond yield less the TIPS yield, the Fed’s buying of TIPS could drive down TIPS yields and drive up the breakeven measure of inflation expectations, which have risen in line with the Fed’s aggressive buying, as depicted in the following chart.
While the first chart shows increased Fed TIPS holdings from 2016 to 2019, each chart shows TIPS recently declining in the Fed’s portfolio, followed by a sharp pandemic jump, with a commensurate effect on yields. The Fed’s TIPS holdings are a statistically significant factor affecting TIPS yields and breakeven rates.
Surely the Fed knows this effect, but unlike with the much larger, more liquid Treasury and mortgage-backed securities, the Fed has neither disclosed its TIPS buying plans nor discussed the market impact. One could make a case from the first chart that the Fed is seeking TIPS portfolio holdings proportionate to Treasury issuance, but that would be grossly disproportionate to the liquidity of the two markets, thereby having an outsize effect upon yields.
It’s hard not to think that the scale of the Fed’s TIPS purchases is a reflection of the special importance that the Fed attaches to financial-market inflation expectations. Put another way, is the Fed trying to push inflation expectations up? In developing the Fed’s inflation averaging strategy, which “makes up” for inflation undershoots of its 2 percent target, researchers concluded:
[M]akeup strategies do not require that the public completely understand them in order to provide most of their benefits. In [the Fed model], it is only necessary for financial market participants to understand policymakers’ commitment to a makeup strategy.
The Fed’s emphasis on market inflation expectations, coupled with its persistence in driving up breakeven rates, raise questions about its motives. These must be publicly disclosed along with its purchasing strategies and effects.
The Fed’s sophisticated models indicate (a) that inflation below 2 percent has a greater likelihood of prolonging slow growth periods when the Fed’s interest rate is held at zero and that (b) in order to maintain 2 percent inflation, actual inflation must sometimes exceed or “make up” for below-target periods. The technical excellence of the Fed’s analysis of make-up policies and financial-market expectations is belied by its questionable foundation. The Fed’s FRB/US model in the analysis is a type for which “usefulness is debated within economics circles,” according to the Richmond Fed. The Fed has become especially motivated to maintain maximum monetary stimulus since its “Fed Listens” tour in which many speakers favored easy money to boost what they viewed as social justice.
Models are useful in monetary policy and many other fields, and good intentions are great, but how do the Fed’s models and motivations compare to actual experience?
The chart below compares historical inflation and subsequent unemployment, the two fundamental objectives of the Fed’s charter, the latter also an indicator for social justice.
This chart shows that every increase in unemployment is preceded by rising inflation. Every period of declining inflation is followed by lower unemployment. There is no economic benefit to higher rates of inflation. Never in its 107 years of history has the Fed shown the ability to move inflation up and down in a carefully gradated way as it proposes to do with its “make-up” strategy.
The goal of effective monetary policy is stability, not higher inflation. One of the greatest obstacles for the disadvantaged is the “last hired, first fired” syndrome, and boom-bust policy is the enemy of their full participation in our economy.
Recent experience demonstrates this. The recent recovery, the longest in history, interrupted only by pandemic and accompanied by dramatic gains for minorities, never saw inflation above the Fed’s target. The only time in a generation when inflation exceeded 2 percent was followed by the Great Financial Crisis. The amount of monetary stimulus necessary to generate inflation above 2 percent is a threat to financial stability.
All this is not to oppose enormous monetary stimulus in response to the pandemic, but, with record recovery in the third quarter and widespread predictions of above-trend growth this year, the time has arrived for the Fed to develop an exit strategy for monetary stability and maximum economic performance.
Full disclosure of its TIPS balance sheet policies and a commitment to stable inflation rather than vacillating around a target facilitate this goal.
