The Convenience Yield, Inflation Expectations, and Public Debt Growth

U.S. long-term treasury debt serves the important role of safe and liquid assets in the economy, hence carrying significant convenience yields. We present two new findings relating the convenience yield to inflation and government fiscal policy. First, the convenience yield of treasury debt is negatively correlated with inflation expectations. Second, inflation expectations predict future debt-to-GDP growth at different horizons. To explain these findings, we incorporate convenience yields into a staggered-price model with an active fiscal policy. The convenience yield for long-term debt is the discounted value of future convenience service flows, thus is negatively correlated with future debt supply. Furthermore, a government deficit shock leads to both higher debt in the future as well as higher expected inflation simultaneously. The model rationalizes the two empirical findings, and provides a natural framework to study the interactions among inflation, debt growth, and cost of borrowing, particularly the convenience yield component