Inflation-Indexed Bonds Attract Growing Interest

• Pages: 75-76

Page 75

Following is an updated analysis that was featured in the October 1996 edition of the IMF's World Economic Outlook. The analysis appears as part of IMF Working Paper 97/12, The Rationale and Design of Inflation-Indexed Bonds, by Robert Price.

Although inflation-indexed bonds have been advocated by many economists as a useful tool for debt management and monetary policy, indexed bonds remain relatively uncommon. A belief that indexation is in general likely to perpetuate inflation-for example, through wage-price spirals or effects on expectations, and through subsequent pressures for accommodation by monetary authorities-is a major reason governments have been reluctant to offer them. The experience of countries that adopted comprehensive indexation beginning in the 1960s and 1970s bolstered this view. Examples include Argentina, Brazil, Chile, Colombia, and Israel. In these cases, indexation was seen as a way to cope with inflation, and indexation of financial markets, in particular, as an expedient to promote domestic saving and capital formation. By the 1980s, however, inflation performance in a number of these countries had deteriorated, in some cases to the point of hyperinflation, and a number have since taken steps to reduce the scope of indexation. Since the early 1980s, many industrial countries have also abolished wage indexation, which was widely perceived to have contributed to the escalation of inflation in the 1970s.

Advocates of the indexation of government debt instruments argue that it removes the incentive to inflate. Attempts to reduce real debt burdens by generating unanticipated inflation are self-defeating when government liabilities are indexed. Governments therefore are more likely to focus on reasonable price stability as the appropriate monetary policy objective. Indexed bonds may thus enhance monetary policy credibility and in so doing reduce funding costs by the amount of the inflation risk premium incorporated in conventional bonds. Advocates point out that indexation in itself does not foster inflation. Monetary and fiscal policies are at the root of inflation, regardless of indexation; any potential inflationary effects of indexing that occur can be countered by monetary and fiscal policy actions. Advocates generally do not argue for indexing the entire government debt, since there is still a public demand for nominal debt.

Beginning in the early 1980s, a new group of issuers in the industrial...