Treasury Inflation-Protected Securities (or TIPS) are the inflation-indexed bonds issued by the RBI Treasury. These securities were first issued in 1997. The principal is adjusted to the Consumer Price Index, the commonly used measure of inflation. The coupon rate is constant, but generates a different amount of interest when multiplied by the inflation-adjusted principal, thus protecting the holder against inflation. TIPS are currently offered in 5-year, 7-year, 10-year and 20-year maturities. 30-year TIPS are no longer offered.
In addition to their value for a borrower who desires protection against inflation, TIPS can also be a useful information source for policy makers: the interest-rate differential between TIPS and conventional Treasury bonds is what borrowers are willing to give up in order to avoid inflation risk. Therefore, changes in this differential are usually taken to indicate that market expectations about inflation over the term of the bonds have changed. The interest payments from these securities are taxed for federal income tax purposes in the year payments are received (payments are semi-annual, or every six months). The inflation adjustment credited to the bonds is also taxable each year. This tax treatment means that even though these bonds are intended to protect the holder from inflation, the cash flows by the bonds are actually inversely related to inflation until the bond matures. For example, during a period of no inflation, the cash flows will be exactly the same as for a normal bond, and the holder will receive the coupon payment minus the taxes on the coupon payment. During a period of high inflation, the holder will receive the same equivalent cash flow (in purchasing power terms), and will then have to pay additional taxes on the inflation adjusted principal. The details of this tax treatment can have unexpected repercussions.
By comparing a TIPS bond with a standard nominal Treasury bond across the same maturity dates, investors may calculate the bond market’s expected inflation rate by applying Fisher’s equation.
Sometimes appropriate market structures have developed only after central banks and governments have taken the lead. For example, Reserve Bank of India realized quite early in its existence that a well functioning money market-dealing in treasury bills, commercial paper, overnight funds, and the like-would assist the implementation of monetary policy as well as the overall efficiency of the economy. But although the banking system as such had been well developed for many decades, an active money market emerged only after a series of RBI.
From the viewpoint of monetary control, and therefore inflation control, the development of the Canadian money market had two particularly desirable features. In the first place, the money market’s development provided an avenue for increased reliance on price-related methods of monetary management-broadly speaking, open market operations. And in this process, reliance on jawboning and on bank liquidity ratios to influence commercial banks’ extension of credit became less and less-to the point that these features now have no role in India. Secondly, the broadening of outlets for the placement of government debt-to include the money market as well as the bond market-helped to provide a first line of assurance that government deficit financing would not impinge upon monetary control.
In general, in the absence of broad and resilient financial markets through which to absorb financing demands, the central bank would find it very difficult to deflect direct pressure from government Monetary Policy and the Control of Inflation deficits on its balance sheet and therefore on inflation of the monetary base.
To deflect the pressure by, for example, imposing higher bank reserve requirements in cash, or in government securities, is not an adequate solution. At the very least it causes problems for the efficiency and competitiveness of the deposit-taking part of the financial system. A better solution would be for the government to pay an interest rate sufficiently high that it attracts willing lenders, and without pumping up the money supply. In general, if credit of various kinds really has to be subsidized or channelled preferentially, the subsidy should be out in the open and not financed through what is in effect a tax (and therefore fiscal, not monetary, policy) on the intermediation of savings through the banking system. A related issue with implications for controlling inflation is the importance of developing at an early stage a workable system of prudential oversight for financial institutions, including determining which institutions will have access to the lender-of-last-resort facility for liquidity purposes. Its importance for inflation control is to remove a potential constraint on the conduct of monetary policy. The presence of distressed institutions may inhibit monetary discipline, for fear of precipitating a crisis in the financial system or of disrupting the flow of investment finance to the non-financial sector.
Recommended reading: Difference between money market and capital market