The Role of Inflation-Linked Debt in Us Government Finances

Evidence of a liquidity penalty on Treasury Inflation-Protected Securities (TIPS) is often cited as a reason the Treasury should eschew the issuance of inflation protected securities. Conventional wisdom has been that this liquidity cost more than offsets the benefit to the Treasury of not having to pay higher yields to compensate investors for an inflation risk premium. This paper reviews the use of inflation-linked debt by the US government in the form of both the TIPS program and the much smaller I bond program. While the liquidity penalty has not decreased, the once-prominent gap between break-even inflation rates implied by the TIPS-Treasury spread and several measures of inflation expectations has narrowed dramatically since 2021. This finding implies that the inflation risk premium has increased to a point where it is nearly large enough to outweigh the liquidity penalty, making a case for the Treasury to monitor the inflation risk premium and increase TIPS issuance if the inflation risk premium remains elevated. The case would be even stronger if the Treasury were to undertake simple measures to increase the liquidity of inflation-linked debt. If the government actually wishes to limit the stealth tax represented by inflation, it can do so by raising the share of inflation-indexed debt and making such debt more liquid.