Inflation Expectation and Asset Allocation in the Presence of an Indexed Bond

Abstract

Optimal asset allocation choice for long term individual investors is complicated by inflation expectation. This article analyzes how anticipated rate of inflation influences asset allocation decision of US investors who employ a subjective equilibrium allocation approach in which investors include their inflation forecasts based on a survey of consumers' price expectations and the interest rate model in the optimization process. The universe of asset choices includes a newly introduced Treasury inflation protected securities (TIPS), equity, real estate, Treasury bonds and corporate bonds. This study shows that in an event of higher anticipated rate of inflation investors should allocate more wealth to TIPS and reduce their exposure to Treasury bonds, corporate bonds and equity.