Expanding the US Treasury's Use of Inflation-Linked Debt
A Path to Lower Borrowing Costs and Fiscal Responsibility
During the inflationary macroeconomic environment of the past two years, Treasury Inflation-Protected Securities (TIPS) and Series I Bonds have gained increasing attention from investors seeking a refuge from the uncertainty of inflation. Launched in 1997, these inflation-linked bond programs of the US government still account for a small percentage of the Treasury's outstanding debt: TIPS made up just 6.1%, and I Bonds a mere 0.2% as of May 2023.
With the interest Treasury is paying on its inflation-linked securities having risen by $723 million in FY 2022, one’s first reaction might be to think that we should be relieved that the Treasury didn’t issue more inflation-linked debt, and that going forward it should issue even less of the stuff.
However, the opposite is true. Congress and the Treasury should reform the TIPS program by making the market for these securities more liquid, and the US government should issue more inflation-linked debt. Once liquidity problems are solved, inflation-linked debt will allow Treasury to lower its expected borrowing costs. Inflation-linked debt offers the Treasury the benefit of not having to compensate investors for an inflation risk premium and encourages Congress to worry more about the possible inflationary effects of their policies.
TIPS, the main inflation-linked US bond instrument, provide investors with a stream of interest payments that do not fluctuate in real terms, by adjusting the principal based on the Consumer Price Index for All Urban Consumers (CPI-U). The interest rate remains the same over the security's lifetime, but the principal is increased with inflation so that it retains its real value. The tax treatment of TIPS is unusual, with both the principal adjustment and semiannual interest payments being taxed. This results in unrealized gains on a TIPS security creating a tax liability for the holder.
Absent other differences — an important caveat we come back to below — inflation-linked debt should be more attractive to investors than regular, nominal securities of the same issuer. The cost at which Treasury can issue its regular nominal bonds reflects a real yield, plus expected inflation, plus an inflation risk premium to compensate investors for bearing the risk that inflation might be higher than expected.
Other things equal, the expected cost of issuing TIPS would be the same but without the inflation risk premium. That is no small difference. This inflation risk premium alone according to the Federal Reserve generally increases the interest rate on Treasuries by anywhere from 0.2 to 0.5 percentage points. As of June 2023, that would amount to anywhere from $45 to $112 billion annually in compensation it pays to the holders of its bills, notes, and bond to remain uninsured against unexpected inflation.
Unfortunately, there is another factor at play. TIPS in their current form lack the money-like qualities that nominal Treasuries possess, necessitating a higher real yield to compensate investors for the lack of liquidity associated with them.
But does this liquidity penalty really mean the Treasury should reduce or abandon inflation-linked debt? Some observers think so. Several members of the Treasury Borrowing Advisory Committee have suggested that the Treasury slow down its issuance of inflation-linked debt, and Canada's Finance Minister Chrystia Freeland terminated the country's inflation-linked debt program in November 2022.
However, these arguments are based on two flawed notions. First, they assume the liquidity penalty that the Treasury pays in TIPS is not fixable. Second, they ignore the fact that investors ultimately demand protection against unexpected inflation and that if the liquidity differences could be eliminated, inflation-linked debt would be cheaper in expectation for the Treasury to issue.
According to our forthcoming research, it’s not even clear that the liquidity penalty outweighs the benefits to the Treasury from not having to pay the inflation risk premium, particularly during times when investors are worried about inflation. Nonetheless, the Treasury could make the liquidity cost issue moot by fixing the TIPS program. Changing the tax treatment of TIPS and increasing issuance would create a more liquid market that would reduce the liquidity cost currently associated with issuing inflation-linked debt. This would decrease the compensation investors require to hold TIPS and enhance the program's savings relative to nominal debt.
The Treasury could even discard the separate classes of TIPS maturities and simply issue perpetuities, or bonds which never mature. A perpetual TIP pays $1 at a regular interval, adjusted up or down as the price index rises or falls, forever. That doesn’t necessarily mean that the Treasury is stuck with the bonds forever, though. It Treasury could retire the perpetuities by repurchasing them at market prices.
This reform takes a page out of the playbook of Sir Henry Pelham who as UK Prime Minister and Chancellor of the Exchequer in 1751 first issued perpetual gilts in the form of consol bonds, though these were not inflation-linked. The US government also issued perpetual bonds in the late 19th and early 20th centuries, and a number of commentators have called for it to do so again.
Making TIPS perpetual would address the key liquidity problem the program faces, namely the relatively small market for any given bond given the numerous maturities extant in the market at any given time. The beauty of perpetual bonds is that once issued they all have the same maturity date – never.
An additional avenue to help increase TIPS liquidity would be to reindex new securities in the future. The current CPI-U index is unstable over short periods of time, resulting in adjustments that often dramatically change the principal value. Indexing TIPS to a three-month average CPI-U could address these volatility concerns without sacrificing long-term inflation tracking.
Moreover, an increased reliance on inflation-linked debt could encourage fiscal responsibility within the government. There is increasing recognition that government spending is closely tied to inflation in an economy, and the recent work on the Fiscal Theory of the Price Level by John Cochrane has buttressed this idea with a coherent model of exactly how and why. If Congress were forced to consider the potential increase in interest payments due to inflation caused by their fiscal programs, they might exercise greater caution when evaluating large spending packages. This, in turn, would lower expected inflation rates and the inflation risk premium investors demand, ultimately saving the government money on debt issuance.
The savings from issuing liquid inflation-linked debt would be especially great during times when the liquidity risk premium is high, such as during 2022 when fears of inflation were at their recent peaks. So in addition to reforming the program Treasury should also monitor the inflation risk premium and shift its balance towards the inflation-linked debt accordingly.
TIPS might currently be a relatively unfavorable security for the Treasury to issue due to their messiness and illiquidity. However, if the government addresses the relative lack of liquidity in the TIPS market, the Treasury could save money in the long run by increasing its issuance of inflation-linked debt, due both to savings on the inflation risk premium and to the increased fiscal responsibility that emerges when policymakers have a strong incentive to care about inflation.
[Note: A more extensive discussion is provided the full-length paper by Joshua Rauh, “The Role of Inflation-Linked Debt in US Government Finances,” Mercatus Policy Research, July 2023.]