A Model-Independent Maximum Range for the Liquidity Correction of TIPS Yields

Abstract

The difference between nominal and real Treasury yields, also known as break-even inflation (BEI), is biased as a measure of inflation expectations and the associated risk premium due to liquidity differentials between nominal and real yields. In this paper, we use the additional information in inflation swap rates to construct a model-independent measure of the maximum range for the liquidity correction to real Treasury yields – also known as Treasury Inflation-Protected Securities (TIPS). In the empirical analysis, using the model of nominal and real yields introduced in Christensen, Lopez, and Rudebusch (2010), we show how the maximum range of liquidity-corrected TIPS yields converts into a maximum range for the estimated inflation expectations and their associated risk premium. We exploit the admissible range for the estimated inflation risk premium (IRP) to calculate a conservative measure of the benefit of TIPS to the U.S. Treasury by taking the smallest estimated IRP and deducting the maximum TIPS liquidity premium as well as the on-the-run nominal premium. At the ten-year maturity, the average of this measure over our sample is 7 basis points, leading us to conclude that the U.S. Treasury has benefited from issuing TIPS.