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Number 95-32, September 29, 1995

Inflation-Indexed Bonds
A number of industrial countries have recently
started issuing inflation-indexed government securities: that is, bonds with yields that rise and
fall with inflation. The UK. was among the earliest, inaugurating such bonds in 1981, followed
by Australia in 1986, and by Sweden and Canada in the early 1990s; New Zealand is expected
to join the ranks in the near future. Whether or
not the US. also will offer such bonds is a matter
of ongoing public discussion. A congressional
hearingon the topic in 1992 was the most recent
This Weekly Letter examines the basic mechanics
of inflation-indexed bonds and their purported
benefit in aiding monetary policymakers. With a
stock of indexed bonds outstanding, the nominal
cost of the government's debt financing automatically increases as inflation goes up. This feature
of indexed bonds makes them a good mechanism
for enhancing the credibility of a government's
commitment to a low-inflation policy in the future. Indeed, this feature might be an important
reason for the recent popularity of inflationindexed bonds among industrial economies.

How inflation-indexed bonds work
A typical long-term government security is redeemed at its face value at maturity, and periodic
coupon payments are fixed in nominal terms. So
at any date, its real yield at maturity is uncertain,
as inflation and thus the purchasing power of
money in the future is uncertain. In comparison,
an !nf!ation-indexed bond guarantees holders a
real rate of return by compensating them for the
eroded purchasing power of nominal payments
due to inflation. For example, consider the UK.
version of indexed bonds, which are called "indexed gilt!' Their semiannual coupon payments
are based on the inflation-adjusted face value of
the bond over time. The adjustment for inflation
is made using the Retail Price Index (RPI) with an
eight-month lag. At maturity, the redemption value
also is adjusted for the actual inflation between
the initial indexation date and eight months prior
to the maturity date. Because of this indexation
lag, an indexed gilt will be exposed to inflation

risk in the final eight-month period. However,
this does not appear to be crucial, since many
indexed gilts have maturities of over fifteen years.
At a theoretical level, the provision of an asset
that is free from inflation risk should improve the
general welfare, both on the buyers' side and on
the sellers' side. On the buyers' side, such an
asset offers a means of adjusting portfolios for
individual investors with different risk and return preferences. For example, investors, such as
pension funds, that want to secure a predictable
flow of real cash payments could include indexed bonds in their portfolios. Indeed, when
they were first issued in 1981, indexed gilts were
offered only to pension funds. This restriction
was lifted in 1982, but data from 1994 show that
pension funds and insurance companies still held
close to 50 percent of the outstanding stock of
indexed gilts.
On the sellers' side, the issuing government may
end up with lower borrowing costs in certain
situations. For example, long-term government
bonds generally sell at a discount, which reflects
the yield the market demands. The discount will
be deeper after a high-inflation period, because
markets assess a large premium in interest rates
for expected inflation, as well as a premium for
an inflation risk for holding a nominal asset
whose real value is uncertain over time. Such
a premium might be unacceptably high for a
governmentthat genuinely intends to impose
monetary and fiscal discipline in order to bring
about and maintain low and stable inflation. This
situation is like that faced by the Thatcher administration in 1981, when it started issuing inflationindexed bonds (Woodward 1990, de Kock 1991,
Shen 1995).

Inflation-indexed bonds and
the effectiveness of monetary policy
One of the key benefits of having inflationindexed bonds in addition to conventional nominal bonds is that together they offer a means of
measuring markets' expectations about future
inflation. The problem with obtaining such a

measure from the yield on conventional bonds
alone is that the yield consists of expected inflation, an inflation risk premium, and the expected
real rate-and it is very difficult, if not impossible, to measure one separately from the other.
But since the yield on indexed bonds reflects
only the expected real interest rate, the problem
is solved, theoretically, at least (that is, assuming
that inflation risk is small and well-behaved over
time): One can simply take the difference between the yields on indexed and nominal bonds
with the same maturities, and the result is a
measure of inflation expectations. Such a measureof inflation expectations can aid a monetary
authority by offering timely, market-based feedback regarding the inflationary consequences
of its actions. Presumably, changes in this difference would convey valuable information on
changes in expected inflation that could be incorporated in determining short-term monetary
In practice, however, the problem is not so easy
to solve. Certain preconditions need to be met
for policymakers to use information from indexed
bonds in this way. First, the nominal bonds and
indexed bonds have to have similar characteristics, such as maturity and coupon rate. Thus it
would be preferable to have a variety of indexed
bonds that match the characteristics of current
U.S. Treasury securities. This would afford a more
precise reading of markets' expectations at different horizons (Hetzel 1992).
Second, there has to be sufficient liquidity in the
indexed bond market. The usefulness of indexed
bonds as an indicator hinges on how correctly
changes in their prices reflect changes in the underlying inflation expectations. Therefore, it is
imperative that the market have sufficient depth
and breadth so that non-fundamental factors will
not cause large changes in their yields.
Third, the quality of the price indexes used for
inflation indexation must be high; that is, the
candidate price index has to reflect changes in
the purchasing power of money accurately. It
would be especially problematic ifthe bias in the
price index varied over time. For example, there
is currently some concern about potential bias
in the U.S. Consumer Price Index. A bias arises
due to imprecise measurement of improvements
in the quality of goods, the introduction of new
goods, or substitution on the part of consumers between different goods and retail outlets
(Wynne and Sigalla 1993). This could become

an issue concerning indexed bonds, if and when
they come into being in the U.S.

Indexed bonds as a commitment mechanism
When a government issues inflation-indexed
bonds, it is signaling its intention to contial inflation in the future, since the nominal cost of
debt financing automatically increases as inflation goes up. For example, with ordinary nominal bonds a government faces a stream of
known, fixed, nominal obligations whose real
burden can be reduced by future inflation. With
indexed bonds, the government faces unknown
nominal obligations that will balloon with higher
future inflation. This automatic escalation of
indexed-debt costs offers a potentially binding
mechanism committing the government to noninflationary policies in the future.
This appears to be an important element of the
move by the U.K., Australia, Sweden, and Canada to begin issuing inflation-indexed bonds. At
least two out of the following three characteristics
applied to those countries when they started issuing indexed bonds: (1) a recent history of a
high inflation and large government deficits, (2)
a relatively new and fiscally conservative government that supported lowering inflation, (3)
a central bank with relatively less institutional
Under such circumstances, issuance of inflationindexed bonds was perhaps a practical way to
signal the governments' commitment to low inflation in the future. For example, a much more
difficult way to send the signal would have been
to make the central bank more independent. According to studies such as Cukierman, Webb,
and Neyapti (1992), in industrialized countries
there is a negative correlation between the degree of a central bank's institutional independence and a country's inflation rate. But changing
the institutional structure of a country's central
bank would involve a major legislative effort.
Clearly, providing indexed bonds as an incentive
to keep inflation under control would be much
easier to accomplish.
The experiences of the u.K. and Canada seem to
support this view. In the U.K., the Conservative
party won the election in 1979, following a decade marked by both high inflation and substantial government budget deficits. The Thatcher
administration implemented policies aimed at
cutting government spending and debt and controlling inflation, which were the subject of ran-

corous disagreement, even within the ruling
party. Hence, negotiating a drastic change in the
traditional relationship between the government
and the Bank of England might have been out of
the question. Indexed bonds may have offered a
more practical solution.
Canada is another interesting case. Though its
economy was stable throughout the 1980s, there
was a strong effort to establish price stability as
the official, single goal of monetary policy. A legislative initiative to do so was pushed forward by
the Conservative administration, though it eventually failed in Parliament in the fall of 1991. The
first issuance of indexed bonds immediately followed at the end of 1991.

The provision of inflation-indexed government
bonds appears to be a useful innovation. First, it
would provide an indicator of the markets' assessment of the monetary authority's commitment
to low inflation when indexed and nominal bonds
with matching characteristics coexist, and this
could be valuable in aiding short-run monetary
policy deliberations. Second, it could play an important role in signaling governments' commitment to policies of low inflation in the future.
The existence of indexed bonds adds to the credibility of the commitment, since the government's
cost of debt financing automatically escalates in
tandem with inflation.

Cukierman, A., S. B. Webb, and B. Neyapti. 1992.
"Measuring the Independence of Central Banks and Its
Effect on Policy Outcomes:' The World Bank Economic Review (September) pp. 358-398.
de Kock, G. 1991. "Expected Inflation and Real Interest
Rates Based on Index-Linked Bond Prices: The U.K.
Experience:' Federal Reserve Bank of New York Quarterly Review (Fall) pp. 47-60.
Hetzel, R. 1992. "Indexed Bonds as an Aid to Monetary Policy." Federal Reserve Bank of Richmond
Economic Review Uanuary/February) pp. 13-23.
Shen, P. 1995. "Benefits and Limitations of Inflation
Indexed Treasury Bonds:' Federal Reserve Bank of
Kansas City Economic Review (Third Quarter) pp.

Woodward, G. T. 1990. "The Real Thing: A Dynamic
Profile of the Term Structure of Real Interest Rates in
the United Kingdom, 1982-1989:' Journal of Business,
63, pp. 373-398.
Wynne, M. and F. Sigalla. 1993. "A Survey of Measurement Biases in Price Indexes:' Federal Reserve Bank of
Dallas Research Paper No. 9340.

Chan Huh

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System. Editorial comments may be addressed to the editor
or to the author. Free copies of Federal Reserve publications can be obtained from the Public Information Department, Federal
Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 974-2246, Fax (415) 974-3341. Weekly Letter
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Index to Recent Issues of FRBSF Weekly Letter










Rules vs. Discretion in New Zealand Monetary Policy
Mexico and the Peso
Regional Effects of the Peso Devaluation
1995 District Agricultural Outlook
Has the Fed Gotten Tougher on infiation?
Responses to Capital Inflows in Malaysia and Thailand
Financial Liberalization and Economic Development
Central Bank Independence and Inflation
Western Banks and Derivatives
Monetary Policy in a Changing Financial Environment
Inflation Goals and Credibility
The Economics of Merging Commercial and Investment Banking
Financial Fragility and the Lender of Last Resort
Understanding Trends in Foreign Exchange Rates
Federal Reserve Policy and the Predictability of Interest Rates
New Measures of Output and Inflation
Rebound in U.S. Banks' Foreign Lending
Is State and Local Competition for Firms Harmful?
Productivity and Labor Costs in Newly Industrializing Countries
Using Consumption to Track Movements in Trend GDP
Output-Inflation Tradeoffs and Central Bank Independence

Mattey ISpiegel

The FRBSF Weekly Letter appears on an abbreviated schedule in June, July, August, and December.