Reflections on the Treasury Inflation-Protected Securities Market

Reflections on the Treasury Inflation-Protected Securities Market - FEDERAL RESERVE BANK of NEW YORK

Speech

December 13, 2007

William C. Dudley

, Executive Vice President

Remarks at the Forecasters Club, New York City

Today I want to talk about a security market that should offer safety during

this period of financial market turbulence—the Treasury Inflation-Protected

Securities or TIPS market. Now that this market is more than 10 years

old, it should be sufficiently mature to permit a fair evaluation of its efficacy

as a funding vehicle for the U.S. Treasury. Some research studies have

concluded that the incremental financing costs associated with the TIPS program

have been substantial, leading some to conclude that the costs may outweigh

the benefits. Today I am going to lay out the reasons why I disagree

with this conclusion.

Put simply, I come here to praise TIPS… In my opinion, the benefits

of the TIPS program significantly exceed the costs of the program.

Before saying anything more, let me emphasize the phrase in the prior sentence—“in

my opinion.” The views that I express today are my own and may

not represent the views of the Federal Open Market Committee, the Federal Reserve Bank of New York or

the Federal Reserve System.

The logic of issuing inflation-protected securities is straightforward. Wouldn’t

some investors pay a premium—that is, accept a lower expected return—in

exchange for guaranteed, full compensation for inflation? Because the

United States and a number of other countries decided that the answer was likely

enough to be “yes,” they developed an inflation-indexed government

debt market.

Has the program been a good development from the perspective of the U.S. Treasury? What

about from the public’s perspective?

A good starting point for answering these questions is to account for the

costs and benefits of the program relative to an appropriate counterfactual. For

example, we might start by comparing the difference in funding costs to the

Treasury of TIPS versus a program of comparable duration nominal Treasuries.

But we should also be careful not to ignore other potential benefits of the

TIPS program. As I see it, these potential benefits include:

Greater diversification of the Treasury’s funding sources, which

presumably has favorable implications for the Treasury’s funding costs.

The potential for TIPS issuance to reduce the variability of the U.S. government’s

net financial position.

Access to a market-determined measure of inflation expectations that can

help inform the conduct of monetary policy.

The provision of a virtually risk-free investment that provides value to

risk-averse investors.

Although it is difficult to quantify these benefits, I will argue that they

are considerable and should not be ignored in evaluating the benefits of the

TIPS program.

Turning first to the issue of measuring the impact of TIPS issuance on the

government’s funding costs, this could be done simply by comparing the

ex-post

costs

of a program of TIPS issuance to the costs of a comparable program of nominal

Treasury issuance. Studies of this sort have typically shown that TIPS

issuance has resulted in a higher net cost to the Treasury. For example,

a 2004 paper by Brian Sack and Robert Elsasser found a net cost to the Treasury

from the start of the program through early 2004 of slightly less than $3 billion.

A more recent paper by Jennifer Roush of the Federal Reserve Board finds that

total

ex-post

costs of TIPS through March 2007 were in the range of

$5-8 billion. Unfortunately, although this methodology is attractive

in its simplicity, it has some flaws that undercut its usefulness in reaching

conclusions about the attractiveness of the TIPS program.

The problem with an

ex-post

analysis is that it depends critically

upon the performance of inflation over the period in question. If

inflation turns out to have been meaningfully different than what was expected

at the time of TIPS issuance, then this difference—the so-called “inflation

surprise”—can be important in affecting the relative costs of TIPS

versus nominal Treasury issuance. If inflation turns out to be

higher than expected, then TIPS issuance will likely look to have been more

expensive than nominal Treasury issuance. If inflation turns out lower,

ex-post

analysis will likely show a saving from the TIPS program.

Over the long run—and I mean the

very

long run—there

should be roughly as many downward surprises in inflation performance as upward

surprises. But within any relatively short period, such as the last

decade, this certainly does not need to be the case. In other words,

over such a short period, the outcome of an

ex-post

analysis can be

heavily influenced by which of the two sides—the Treasury or investors—was

the lucky recipient of the net inflation surprise that occurred over the period

in question.

For example, in countries, such as the United Kingdom, where inflation declined

following the inception of an inflation-linked debt program,

ex-post

studies

generally suggest that these programs have reduced financing costs for these

countries.

The fact that the Treasury saved or lost money

ex post

is thus not

a very reliable guide as to whether the strategic decision to implement a TIPS

program has been a good idea. The relevant question is whether the Treasury

obtained the financing it needed at a lower

ex- ante

cost. If

the experiment were to be run thousands of times drawing from the underlying

distribution of possible inflation outcomes, would Treasury’s costs have

been lower, on average, with TIPS or with nominal Treasuries? To conclude

on the basis of one coin flip or roll of the dice as

ex-post

analysis

essentially does surely is not the best way to evaluate the respective costs

of TIPS issuance versus nominal Treasuries.

To execute an

ex-ante

analysis, we need a real-time measure of the

inflation expectations of TIPS investors that is not contaminated by premiums

for inflation risk or liquidity differentials. Unfortunately, we don’t

have a perfect measure. Nevertheless, we may be

able to get close. We do have estimates of expected inflation from other

sources—such as the Survey of Professional Forecasters (SPF) conducted

by the Federal Reserve Bank of Philadelphia. If such measures do indeed

reflect the inflation expectations of investors, then we can conduct a reasonably

accurate

ex-ante

analysis.

TIPS analysts often talk about a concept they call the breakeven inflation

rate. Essentially, this is the realized inflation rate that would cause

investors to come out the same in terms of total compensation regardless of

whether they had bought TIPS or nominal securities. If inflation comes

in above the breakeven rate, the investor who bought TIPS comes out ahead

post

; if inflation comes in below the breakeven rate, the investor who

bought nominal securities wins. When I wrote this speech, the breakeven

inflation rate at the ten-year maturity point was about 2.4 percent. This compares

to the Philadelphia Survey of Professional Forecasters’ most recent long-run

estimate for CPI inflation of 2.4 percent. If we assume that the SPF fairly

represents the expectations of investors, then the current constellation of

data indicates that investors are roughly indifferent between the benefit of

being protected against inflation risk versus the cost in terms of the greater

illiquidity of TIPS relative to on-the-run nominal Treasuries. Thus,

on an

ex-ante

basis, it appears that the cost of issuing TIPS is currently

about equal to the cost of issuing nominal Treasuries. From this perspective,

there appears to be no net benefit or cost from TIPS in terms of expected financing

costs.

That does not sound very compelling for TIPS. But I think it is important

to emphasize that this standoff is occurring at a time when the preference

for liquidity is especially strong. This benefits nominal Treasuries

versus TIPS. When market turmoil subsides and this liquidity premium

shrinks, one might expect TIPS to move ahead on an

ex-ante

basis.

Even on an

ex-post

basis, a detailed analysis of the timing of the

net costs of TIPS issuance suggests that continuing a TIPS program makes sense. In

her examination of the

ex-post

costs of the TIPS program, Jennifer

Roush finds that the entire cost occurs during the early years of the TIPS

program—up until around 2004. Roush’s analysis suggests that

there were large startup costs associated with the TIPS program. Initially,

TIPS were quite illiquid and investors demanded significant compensation for

this illiquidity. But as the market developed, this illiquidity discount

shrank.

The important point to take away from Roush’s analysis is that the large

startup costs of the TIPS program have passed and are now, in essence, sunk

costs. Thus, if the question is whether the TIPS program should be continued

on the basis of expected interest expense, then the answer appears to be “yes.” Since

2004, TIPS issuance appears to have saved the Treasury money and the program

appears likely to be “profitable” from the perspective of the Treasury

on an ongoing basis.

So it’s TIPS by a small margin at this point. But that’s

before we have included some of the other considerable—although more

difficult to quantify—benefits associated with TIPS issuance.

Let me now discuss some of these other benefits. The comparison

between the prevailing interest rates on TIPS versus nominal Treasuries provides

insight into the relative costs associated with issuing the last dollar of

debt. Is the

marginal

cost of TIPS lower than the marginal cost

of nominal Treasuries? But just as important is whether TIPS issuance,

by displacing nominal Treasury issuance, reduces the

average

cost

of nominal Treasuries. This would occur if TIPS were not perfect

substitutes for nominal Treasury securities and if the demand for nominal Treasuries

were downward sloping—i.e., not completely elastic.

The first condition almost certainly holds given the different attributes

of TIPS versus nominal Treasuries. If they were perfect substitutes,

then there would not be a liquidity premium for nominal Treasuries versus TIPS. The

second condition almost certainly holds because numerous studies have found

that an increase in the net amount of Treasury borrowing leads to higher expected

borrowing costs for the Treasury.

How big might this effect be? To get an idea of potential magnitude

let’s make two assumptions. First, let’s assume that TIPS

and nominal Treasuries are not substitutes at all. This is too strong,

but it will make it simpler to think through the analysis and it will be offset

by a second assumption that will be on the conservative side.

Second, let’s assume that each $100 billion increase in Treasury issuance

leads to a 1 basis point increase in nominal Treasury yields. In contrast

to the first assumption, this assumption appears to be very conservative. After

all, a study by Thomas Laubach that looked at the impact of a one percentage

point increase in the projected debt-to-GDP level (about $140 billion currently),

found that such an increase could be expected to raise the future level of

interest rates by about 4 basis points. This is not quite the same comparison

because he was focused on an increase in the expected amount of debt outstanding

and we are looking at a change in the composition of Treasury debt issuance. Nevertheless,

it suggests that our 1 basis point assumption may be in the ballpark—it

certainly does not seem, on the face of it, to be unreasonably large.

Applying this 1 basis point saving to the entire stock of nominal marketable

Treasury debt outstanding—after all, we are arguing that less nominal

issuance reduces the average cost of all nominal marketable Treasury debt (about

$4 trillion), this would imply a saving from TIPS issuance of about $400 million

per year. While this estimate provides a false level of precision,

it does suggest that the magnitude of the potential saving from this source

is not trivial, especially viewed relative to the

ex-post

cost estimates

of the TIPS program discussed earlier.

The second noteworthy benefit that stems from TIPS issuance is the fact that

it reduces risk to the U.S. government in terms of the variability of its net

financial position. Although the U.S. Treasury historically has focused

on the net interest expense and rollover risk associated with funding the U.S.

budget deficit, one could argue that this is an incomplete set of objectives. The

Treasury might also take into consideration the goal of minimizing the volatility

of its net financial position. After all, this goal is consistent with

Treasury’s long-repeated policy of maintaining regular and predictable

debt issuance to help minimize net interest costs.

So what role might TIPS play in this regard? That’s simple. The

rate of inflation influences both the cost of TIPS and the government’s

tax receipts. Thus, some level of TIPS issuance may reduce the variability of the government’s net financial

position. This, in turn, should lead to a more regular and predictable

pattern of issuance, which should help minimize interest costs.

The potential role of TIPS in terms of the asset-liability management of the

government’s fiscal position is just the flip side of the role of TIPS

for entities such as pension plans that have liabilities linked to inflation. The

Treasury has assets in the form of anticipated tax revenue that are sensitive

to inflation. If this is the case, it may make sense for its liabilities—its

expected borrowing costs—to also have some sensitivity to unexpected

shifts in inflation. In contrast, for a pension plan in which benefits

are indexed to inflation, it is just the reverse—it is useful to have

assets that are sensitive to inflation.

The point I want to emphasize here is that the Treasury’s borrowing

decisions should be made within an asset-liability management framework. The

goal is not just to minimize the government’s net interest expense. If

that were the case, then all borrowing should occur in the Treasury bill market

given that the yield curve is upward sloping on average. Instead, the

Treasury’s borrowing regime should consider many elements including interest

expense, rollover risk, and the impact of the borrowing regime on the variability

of the government’s net financial position. I am only suggesting

that the last factor—the impact of borrowing on the variability of the

net financial position—should be added to the mix and that the role of

TIPS should be evaluated in that context.

The third noteworthy benefit from the TIPS program is the value of TIPS as

a tool for assessing inflation expectations. Because keeping inflation

expectations well-anchored is so important in keeping inflation itself in check,

real-time measures of inflation expectations may lead to better monetary policy-making. This,

in turn, should improve macroeconomic performance. Although this is very

difficult to quantify in terms of value, I think it is safe to say that in

a $14 trillion economy, even a modest improvement in performance generates

large dollar benefits.

U.S. policymakers focus on four broad sets of inflation expectation measures:

The University of Michigan Survey of Consumer Sentiment measures

of household inflation expectations.

The Federal Reserve Bank of Philadelphia Survey of Professional Forecasters.

Periodic internal surveys of primary dealers, which include questions

about long-run inflation expectations and uncertainty about the inflation

outlook.

Breakeven inflation rates and forward breakeven inflation rate measures,

both calculated by comparing the yields on nominal Treasuries to the yields

on TIPS.

But in practice, the value of the first three measures is limited by the lack

of timeliness—new data become available only monthly, about every six

weeks, or quarterly. Also, real money isn’t riding on the accuracy

of the survey responses. In contrast, the comparison between nominal

Treasury and TIPS yields represents the consensus of market participants.

For these reasons, policymakers put considerable weight on the inflation expectations

proxied by the difference between nominal Treasury note and TIPS yields. Here

the emphasis is not on the break-even inflation rate as implied by, say, the

5-year Treasury notes versus 5-year TIPS or 10-year Treasury notes versus 10-year

TIPS, but instead on forward measures of breakeven inflation.

For example, the 5-year, 5-year forward breakeven inflation measure is a very

important part of the monetary policymaking process. Without a TIPS market,

this tool would be unavailable and I think it would be safe to say that monetary

policy would suffer as a consequence.

How much is this tool worth? Of course, it is very difficult to say. Perhaps,

we would flatter ourselves and think that we could do just as well without

such a market-based, real-time measure of inflation expectations. But

I doubt it. After all, inflation expectations, when untethered, are very

difficult to re-anchor. TIPS help make it easier to keep inflation expectations

firmly in check.

Finally, TIPS offer a benefit to investors because they have less risk than

any other asset class. With virtually no credit risk or inflation risk,

TIPS are one of the safest of investments.

For

investors that want such safety, TIPS offer significant benefits. How

much is this worth? Is the value of this completely captured in the relative

interest costs of TIPS? Probably not, because the relative interest costs

between TIPS and nominal Treasuries are set at the margin. I think there

is some value in having a high-quality hedge to inflation risk, especially

one that is available to less sophisticated investors.

Hopefully, I have convinced you that the benefits of an ongoing TIPS program

exceed its costs. So now I want to turn to a related question: Are

there ways to increase the benefits?

I would be willing to make two modest suggestions here. First, it may

make sense to emphasize longer-dated TIPS issuance rather than shorter-dated

issuance. Analytically, the logic goes as follows. Inflation uncertainty

is likely to increase at longer time horizons. Thus, investors are likely

to pay a greater premium for inflation protection at longer-time horizons. This

implies that the cost savings associated with TIPS are likely to be greater

for longer maturities rather than shorter maturities.

This prediction is supported by empirical studies that have examined the premium

that investors pay for inflation protection both in the United States and elsewhere. For

example, a recent study by Brian Sack of Macroeconomic Advisors finds that

forward breakeven inflation rates increase as maturity lengthens. In

contrast, the level of survey-based measures of inflation expectations is quite

constant beyond a time horizon of a few years. This means that the difference

between forward breakeven inflation and inflation expectations climbs as the

time horizon extends. This strongly suggests that the premium that investors

pay for inflation protection increases as maturities lengthen.

Second, it may make sense to concentrate TIPS issuance and limit the number

of outstanding issues. This might increase the liquidity of outstanding

TIPS issues. That might help reduce the illiquidity discount associated

with TIPS relative to on-the-run nominal Treasury securities.

Long live TIPS! That’s my conclusion. Thanks for your attention.

__________________________________

Special thanks to Jennifer

Roush and David Wilcox at the Federal Reserve Board and my colleagues at

the Federal Reserve Bank of New York—Michelle Steinberg, Debby Perelmuter,

Lorie Logan, Joshua Frost and Lara Green-Spector for their insightful

comments and suggestions.

There is some inflation

basis risk in that TIPS are based on the not seasonally adjusted consumer

price index and a household’s expenditure basket might differ from

the basket in the CPI. Also, pension and endowment liabilities may

be more closely related to other inflation or wage measures than the CPI.

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