When Do TIPS Prices Adjust to Inflation Information?

This event study of market efficiency found that prices of Treasury Inflation-Protected Securities (TIPS) adjust to inflation information without delay during the U.S. Consumer Price Index (CPI) survey period and even before the beginning of the survey period. The cumulative effect of unexpected inflation on the TIPS holding period returns peaks at the end of the survey period. After the CPI announcement, there is no discernible price adjustment. A basic tenet of financial theory is that the market-determined price of a security that promises future cash flows should incorporate changes in inflation expectations over the life of the security. The degree of market efficiency in this regard, however, has been difficult to measure. Tests of how quickly new information about future inflation is incorporated into security prices have been complicated by the presence of many factors other than inflation that affect market prices on a daily basis. Moreover, demonstrating the efficiency of the response of security prices to inflation as it occurs and before its announcement has been difficult. Given the direct link between future cash flows and the ex post U.S. Consumer Price Index (CPI), Treasury Inflation-Protected Securities (TIPS) are uniquely structured to aggregate inflation information before the monthly public announcement. Because the cash flows associated with TIPS depend on actual inflation and a contractual real return, TIPS prices react far differently over time than do conventional bond prices, which respond to changes in the expected rate of inflation until maturity and in the expected real rate. Assuming contemporaneous adjustment of the contractual cash flow to the current CPI, TIPS prices respond to changes in actual inflation and in the expected real rate. Using pooled time-series, cross-sectional data from three recently matured TIPS issues, the authors investigated how quickly TIPS prices respond to the monthly update of the CPI. Their results suggest that TIPS prices efficiently aggregate near-term inflation information. The evidence supports a market that is highly informed about upcoming inflation starting 44 business days before the CPI announcement date. In fact, using the pooled data of all three issues, the authors found that 29 percent of the cumulative adjustment to information about the upcoming month’s inflation is already incorporated into the TIPS prices before the survey period begins. Moreover, the cumulative effect of unexpected inflation on TIPS returns peaks on the last day of the month as the sampling ends, with 98 percent of the inflation adjustment already in the TIPS prices. On the announcement date, the TIPS prices make the final adjustment to correct a reversing trend during the compilation period. The significant adjustment on the announcement date returns the cumulative effect to a level slightly higher than the level at the end of the month. Thus, the market is very efficient at monitoring and responding to changes in consumer prices. Using the monthly CPI survey published by the Blue Chip Financial Forecasts instead of the breakeven inflation rate to measure expected inflation, the authors found no significant difference in the timing of TIPS price adjustments. This finding suggests that the market-determined measure of expected inflation, even for securities with a five-year maturity, is robust in capturing near-term inflation surprises. To isolate the timing parameters of the TIPS price adjustments to inflation information, the authors used a regression model with three control variables based on TIPS trading and indexing characteristics. The three control variables contribute to an overall improvement in modeling TIPS holding period returns (HPRs). One important construct in the modeling of the TIPS HPR is an expected one-to-one response between the TIPS HPR and the total effect of inflation. The authors found that the hypothesis of a one-to-one relationship holds, and they demonstrated that TIPS prices move directly with past inflation (a proxy for “ongoing” inflation) and the arrival of new inflation information during the observation window. The authors’ results are consistent with profit-motivated inflation forecasting by economists and financial analysts that speeds up the TIPS price adjustment process.