What are TIPS?

A WSJ article on the bond market got me thinking.  What are TIPS?

The Treasury Direct explains TIPS like this:

Treasury Inflation-Protected Securities, or TIPS, provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater. 

In the WSJ article, the author showed a graph that showed that the difference between 10-year bonds and 10-year TIPS was decreasing.  This is an indicator that consumers don't have inflation fears so the real buying power of their income will stay the same or actually increase.  Inflation hurts savers so decreased inflationary expectations is good for savers.  The FED can also use expansionary monetary policy to help stimulate the economy as buying securities won't put upward pressure on prices.

AP Macro students should also be able to apply the formula: r = i - pi^e to see that the real interest rate is increasing.  This bump in the real rate, r, should mean more credit and add to the FED's stimulus.