TIPS, Inflation, and the Dollar

As part of the quarterly refunding announcement, the US Treasury indicated that is considering canceling the 20-year TIP and re-introducing the 30-year TIP. The decision will be announced in November and auctioned in January 2010. TIP issuance is likely to increase next year.

Some observers seem to misunderstand what is going on. One strategist at a large bond house told CNBC to watch the direction of TIPS because it may have a bearing on US government policy. Yet it seems this is putting the cart before the horse.

In their discussions, not only with China, which is played up in the Wall Street Journal, but with domestic investors as well, officials likely learned what we did from talking with our clients and a wide range of market participants. Either as an unintended consequence of the aggressive monetary and fiscal policy, or as conscious effort to reduce the debt burden, the US faces a serious risk of inflation.

Our arguments about the slack in the factor markets (record low capacity utilization rates, rising unemployment, lack of demand for credit) and the output gap, or that inflation expectations, measured, for example, by the 5-year/5-year forwards are higher in Europe (2.81% in France and 3.56% in the UK) than in the US (2.52%) have not been sufficient to ease the inflationary worries.

US officials have been clear, they tend to accept the broad outline of the argument and will likely reiterate it in next week's FOMC statement. But taking a page from the game theorists, how can the US officials drive home the point that they will prevent a sharp increase in inflation? Answer: issue more TIPS and in doing so take on the inflation risk--transferring it from the investor to the US government.

On one hand, it may be seen as a negative that investors are concerned about US inflation. On the other hand, the fact it is positive that the US has the depth and breadth of the capital markets to offer more inflation protected securities. In some ways, issuing more TIPS is an extension of the Treasury's willingness to offer the type (including maturity) that investors want.

The US Treasury seems sensitive to the needs and desires of investors. To be clear, although there will be much talk that the US move is to appease China, investors including many domestic investors have similar anxiety. Issuing more TIPS is part of the way officials can secure their "supply lines" of capital. Of course, because the current account deficit has fallen considerably, there is less need for foreign capital, but it is still important and the stock of foreign holdings remains considerable.

That some investors would be content to out-source the risk of inflation to the US government, it suggests greater TIP issuance may reduce some pressure on the US dollar. Behind many dollar bears' argument is that the US will debase its currency through inflation. The Treasury is saying we are so sure that inflation is not a problem and won't be a significant problem, it will take on the risk. So, unlike the analyst on CNBC, the performance of TIPS may not impact US policy as much as US policy is behind the likely shift toward more TIPS issuance.