Government Debt Management and Inflation with Real and Nominal Bonds

Elevated government debt in the wake of unprecedented stimulus packages increasingly raise concerns about a looming return of inflation, as governments may be tempted to monetize debt. In this paper, we examine optimal debt management in the presence of inflation concerns in a setting where i) the government can issue long-term nominal and real (TIPS) 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, but bond prices reflect elevated inflation expectations. Real bond prices are higher, but such debt constitutes a real commitment ex post. We show that the optimal government debt portfolio includes a substantial allocation to real bonds, which lowers inflation levels, inflation volatility, and inflation persistence in equilibrium. The associated lower inflation risk premia are 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 results hold up when accounting for frictions in the TIPS market, such as illiquidity. Our findings suggest that TIPS should be an important tool for debt management in the presence of looming inflation.