EFF: TIPs are obviously a great hedge against inflation, but there is still uncertainty about the short-term real return on long-term TIPS. A long-term TIPS is a long-term loan to the Government at a fixed real interest rate. Variation through time in the expected real return that investors require to make this long-term commitment leads to capital gains and losses that affect short-term real returns.
The interest rate on a one-month Treasury bill is the sum of two pieces, (i) an expected real return and (ii) an expected inflation rate. Month-to-month inflation is quite predictable, so rolling over one-month bills provides a good hedge against inflation. But there is still uncertainty about the long-term real return from this strategy because the expected real return that investors require to hold bills varies through time.
KRF: As Gene says, TIPS are a great inflation hedge, particularly if you buy a bond that matches your investment horizon. For example, suppose you plan to spend a lot of money in ten years and you buy a ten-year TIPS with a promised real annual yield of 2%. The face value of the TIPS is adjusted every six months for the level of inflation over the last half year, so your dollar payoff grows with inflation. As a result, if we ignore the effect of taxes and uncertainty about the rate at which you will be able to reinvest your semi-annual interest payments, your average annual real return over the next ten years is sure to be 2%. Thus, regardless of what happens to inflation, you know exactly how much real spending power you will have in ten years.
In contrast, inflation has a big effect on long-term nominal bonds, such as traditional Treasury and corporate bonds. The inflation rate is persistent; if inflation is unexpectedly high this month, it is likely to remain high for a while. As a result, your purchasing power from a long-term nominal bond is reduced by not just this month's unexpected inflation, but also by the higher expected inflation that accompanies this month's unexpected inflation. For example, if the (non-annualized) unexpected inflation turns out to be 0.1% this month, the purchasing power of a ten-year bond might fall by as much as 2%.
A strategy of rolling over one-month Treasury bills is not quite as good an inflation hedge as a TIPS, but it is a lot better than a long-term nominal bond. This month's unexpected inflation affects your purchasing power by only the amount of unexpected inflation. Because the one-month T-bill rate changes to accommodate changes in expected inflation, unexpected inflation does not have the compounding effect that it has with longer-term bonds. A surge in inflation this month pushes up future expected inflation, but it also increases the returns on the one-month T-bills you will buy in the future. Thus, unexpected inflation of 0.1% this month reduces your purchasing power by only 0.1%.
Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP.