INDEXED BONDS, EXPECTED INFLATION, AND TAX CLIENTELE BIAS

The U.S. Treasury Department has recently issued inflation-indexed bon ds whose yields may be used to provide bond market-based measures of e xpected inflation. This paper suggests that the U.S. tax treatment of the inflation indexation uplift on the principal may create a ''tax cl ientele bias,'' which could cast doubt on the interpretation of the yi eld gap between indexed and conventional bonds as a market measure of expected inflation. This problem is discussed in the context of the Un ited Kingdom, a country where inflation-indexed bonds have been issued for the past 14 years.