04 Oct 2008

Mankiw Is Puzzled By Rising TIPS Yields

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As I explained in a previous post, analysts who rely on the TIPS yield to get the market’s “risk-free real interest rate” are running into all sorts of trouble. But first, let’s quote from that earlier post to remind everyone what TIPS are:

Back in 2003, the Treasury began selling 5-year Treasury Inflation Protected Securities, or TIPS. (Longer maturities were available starting in 1997.) What happens is that the government pays a fixed coupon rate, but the principal is adjusted based on increases in the Consumer Price Index (CPI). Thus, TIPS yields are one of the closest things you can get to observing the real interest rate; it measures what lenders need to be offered to part with their money for a period of time, over and above the fall in the purchasing power of their money.

In that earlier post, I dealt with the anomaly that the market is apparently predicting only very moderate price inflation–around 2%–over the next five years, which seems rather optimistic. Specifically, if you take the yield on regular, old-fashioned Treasurys, and then subtract the yield for TIPS of the same maturity, that should (loosely speaking) give you the purchasing power component. And since five-year nominal yields are only two points above TIPS yields (at least as of that last writing), apparently “the market” is forecasting very modest price inflation over the next five years.

Again, in that earlier post I explained that there at least two problems with this optimistic view. First, the method of simple subtraction shows that the market forecast very badly over the last five years (see chart below). Second, I argued that investors might be worried that the government won’t really allow official CPI increases to reflect the true reduction in the value of the dollar.

Finally we are ready to quote Mankiw and offer a solution to his puzzle:

One might have thought that widespread fear in financial markets would cause a flight to quality, driving the price of safe assets up and their yields down. That certainly has been happening with short-term Treasury bills. But look [below] to see what’s been happening to the yield on 5-year inflation-adjusted government bonds. (Click on the graph to enlarge.) If one wants to flee risky assets and invest safely, for many investors these securities are a pretty good place to be. But their yields, rather than falling, have been rising sharply of late. It’s a puzzle.

To reiterate, one possible explanation for this odd trend is that investors DO NOT TRUST THE GOVERNMENT. Even if an investor is willing to tolerate, say, an annualized real return of only 0.5% over the next five years, if he thinks the Treasury is in such a hole that there will be pressure put on the BLS to further fudge the CPI reports, then the investor might insist on a contractual 2.0% yield on his TIPS.

If I’m right, then the rise in TIPS yields reflects investors’ growing alarm over the solvency of the Treasury, not that they steadily grew much more confident in medium-term US economic growth since the beginning of this year.

(HT2 Pepe for the Mankiw link.)

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