Abstract
We examine the informational content of TIPS yields from the viewpoint of a general 3-factor no-arbitrage term structure model of inflation and interest rates. Our empirical results indicate that TIPS yields contained a 'liquidity premium' that was until recently quite large (~1%). Key features of this premium are difficult to account for in a rational pricing framework, suggesting that TIPS may not have been priced efficiently in its early years. Besides the liquidity premium, a time-varying inflation risk premium complicates the interpretation of the TIPS breakeven inflation rate (the difference between the nominal and TIPS yields). Nonetheless, high-frequency variation in the TIPS breakeven rates is similar to the variation in inflation expectations implied by the model, lending support to the view that TIPS breakeven inflation rates are a useful proxy for inflation expectations.
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