Unfortunately, as a measure of market participants' expected inflation, breakeven inflation has a number of problems (Sack, 2000; Shen and Corning, 2001). First, and probably the most important, breakeven inflation includes a return to investors for bearing inflation risk, implying that the breakeven rate likely overstates the market's expected rate of inflation. Estimates of the inflation risk premium for bonds maturing during the next five to ten years are surprisingly large, generally in a range between 35 and 100 basis points, depending on the time period studied (Ang and Bekaert, 2003; Goto and Torous, 2003; Buraschi and Jiltsov, 2004). If the inflation risk premium averages 50 basis points, for example, then breakeven inflation will overstate the market's true expectation of inflation by half a percentage point, a substantial amount. A further complication is that inflation risk premiums are not constant but instead appear to vary over time as economic circumstances change.
Second, although the issuance of inflation-protected securities has risen significantly, the outstanding quantities of these securities remain much smaller than those of conventional Treasury securities. Moreover, TIPS are attractive to buy-and-hold investors, in contrast to nominal Treasury securities, which are extensively used for trading and hedging (Sack and Elsasser, 2004). For both reasons, the market for TIPS remains significantly less liquid than those for most Treasury securities. All else equal, the likely presence of a liquidity premium in the TIPS return tends to make breakeven inflation an underestimate of expected inflation, thus offsetting to some degree the effect of the inflation risk premium. Like inflation risk premiums, liquidity premiums on TIPS appear to vary over time, further complicating the interpretation of breakeven inflation.
A third issue is that the real values of the coupon payments on an indexed security are fixed by construction, while the real coupons of a nominal bond usually decline over its life. Hence, an indexed security typically has a longer duration with respect to real interest rate changes than does the nominal security, a difference that affects the relative riskiness of real and nominal securities.4 More generally, because TIPS returns are imperfectly correlated with the yields on both nominal Treasuries and stocks, some investors demand TIPS for general diversification purposes--a demand that appears to have increased significantly as investors have become more familiar with this new type of asset. As the supply of TIPS has been fairly limited, the rise in demand by institutional investors and others may push down the equilibrium real return on TIPS and thus raise measures of breakeven inflation.5
A separate issue that bears on the relevance of breakeven inflation for policymaking is that TIPS returns depend on the overall consumer price index (CPI), whereas for many purposes policymakers are more interested in the behavior of core inflation, a measure of inflation that strips out volatile food and energy prices. In fact, TIPS returns appear sensitive to fluctuations in oil prices.