Jan 22, 2010
How do TIPS and one-month Treasury bills compare as inflation hedges?

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 F. Fama
The Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago Booth School of Business
Kenneth R. French
The Roth Family Distinguished Professor of Finance at the Tuck School of Business at Dartmouth College
This information is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. This article contains the opinions of the author but not necessarily Dimensional Fund Advisors and does not represent a recommendation of any particular security, strategy or investment product. Dimensional Fund Advisors is an investment advisor registered with the Securities and Exchange Commission. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

Eugene Fama and Ken French are members of the Board of Directors of the general partner of, and provide consulting services to Dimensional Fund Advisors LP.