Government Debt Management and Inflation with Real and Nominal Bonds

Rising inflation in the wake of unprecedented debt financed stimulus packages raises concerns about a looming return of persistent inflation, as governments may be tempted to monetize debt. In this paper, we ask whether governments can use real (TIPS) bonds as part of the government debt portfolio to commit not to create elevated inflation? We thus examine optimal debt management in a setting where (i) the government can issue long-term nominal and real bonds, (ii) the monetary authority sets short-term interest rates according to a Taylor rule, and (iii) inflation has real costs as prices are sticky. Nominal debt can be inflated away giving ex-ante flexibility, but real bonds constitute a real commitment ex-post. We show that the optimal government debt portfolio includes a substantial allocation to both real and nominal bonds, which lowers inflation levels but increases inflation volatility in equilibrium. The associated lower correlation between inflation risk and government expenditure is reflected in welfare gains through real debt management. Quantitatively, our results are stronger i) the higher the initial debt level, and ii) the longer debt maturity. Our findings suggest that TIPS should be an important tool for debt management in the presence of looming inflation