TIPS: How to decompose the liquidity premium from the inflation-risk premium

Lars Christensen talks about the idea of setting a floor under inflation-linked bonds in order keep inflation expectations at some minimum level. It`s an interesting idea. Here is my comment:

Interesting idea, Lars. One problem here is that the TIPS spread (I’ll use US lingo if you don’t mind) measures not only expected inflation but also the relative illiquidity of TIPS relative to Treasuries. It measures, in part, a liquidity premium.

TIPS might fall to the central bank’s minimum buying price not because inflation expectations have fallen, but because the liquidity of TIPS relative to Treasuries has declined. This change in liquidity could be purely incidental. ie. it could be due to some unimportant technical change unique to Treasury markets. The result would be that the central bank buys up TIPS because it believes inflation expectations have fallen, when in actuality it is the liquidity premium that has changed. According to your rule, the money supply automatically increases, though perhaps it shouldn’t have.

In short, you have to find some way to decompose that portion of the spread between TIPS and Treasuries that is due to the liquidity premium and that which is due to inflation expectations.

It there were publicly traded “liquidity-options” on TIPS, you’d be able price the value of the liquidity premium and use that to back out that portion of the TIPS spread due purely to inflation expectations. Then you could apply your rule more precisely.

In a 2009 speech, FRBNY President William Dudley talks about the illiquidity premium and inflation-risk premium of TIPS here.

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