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BPEA Article

Understanding Inflation-Indexed Bond Markets

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This paper explores the history of inflation-indexed bond markets
in the United States and the United Kingdom. It documents a massive
decline in long-term real interest rates from the 1990s until 2008, followed by
a sudden spike during the financial crisis of 2008. Breakeven inflation rates,
calculated from inflation-indexed and nominal government bond yields, were
stable from 2003 until the fall of 2008, when they showed dramatic declines.
The paper asks to what extent short-term real interest rates, bond risks, and
liquidity explain the trends before 2008 and the unusual developments that
followed. Low yields and high short-term volatility of returns do not invalidate
the basic case for inflation-indexed bonds, which is that they provide a safe
asset for long-term investors. Governments should expect inflation-indexed
bonds to be a relatively cheap form of debt financing in the future, even though
they have offered high returns over the past decade.


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