Understanding Inflation-Indexed Bond Markets

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Abstract
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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