Pricing TIPS and Treasuries with Linear Regressions

We present an affine term structure model for the joint pricing of TIPS and Treasury yield curves that adjusts for TIPS' relative illiquidity. Our estimation via linear regressions is computationally efficient and can accommodate a large number of pricing factors. The baseline specification with seven principal components extracted from Treasury and TIPS yields as well as a liquidity factor generates negligibly small pricing errors for both real and nominal yields. Model-implied expected inflation adjusted for risk premia and liquidity provides a better prediction of actual inflation than unadjusted breakeven inflation. Analysis of model-implied Treasury and TIPS decompositions shows that the Federal Reserve's large-scale asset purchases lowered nominal and real Treasury yields primarily via a reduction of real term premia, the compensation investors demand for bearing real short-rate risk. Real term premia also account for the large response of long-term real forward rates to monetary policy surprises. The deflation floor embedded in TIPS is generally small in magnitude, but spiked during the recent crisis. We also show that the nominal and real term structures from the United Kingdom have qualitatively similar features to the U.S. yields