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Friday, December 14, 2007

Should Treasury Discontinue TIPS?

Some questions about TIPS in another simulated Q&A. This is based upon the speech Reflections on the Treasury Inflation-Protected Securities Market by William Dudley of the NY Fed:

If you don't mind, I'd like to ask you a few questions about Treasury Inflation-Protected Securities or TIPS -- the government bonds that are indexed for inflation. There have been questioned raised about whether the TIPS program should continue. Do we have enough information to make such an evaluation?

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.

What are the objections to the TIPS program?

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.

I like to ask this of everyone I talk to, so please don't take it personally, but some people won't stick around for the whole interview, so would you mind summarizing your conclusions?

Put simply, I ... praise TIPS… In my opinion, the benefits of the TIPS program significantly exceed the costs of the program.

Okay, now let's backup and fill in some detail. Why does the Treasury issue TIPS?

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?

I think I'm supposed to be the one asking the questions [laughs], but that's where I was headed too, so let's go with those. How can we tell whether or not the program has benefited the Treasury and the public?

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.

So simply compare the funding costs under TIPS to what the costs would have been if non-TIPS financing had been used?

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

What are they?

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.

How do we measure these benefits?

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.

What can we measure, how do we measure it, and what do the results show?

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.

Easy enough to do. Is the analysis widely accepted?

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.

One of the things that makes the method simple, of course, is the use of "ex-post" real interest rates, i.e. the nominal interest rate minus the actual inflation rate, instead of the "ex-ante" real rate, i.e. the nominal interest rate minus the expected inflation rate. That allows us to use actual inflation rather than expected inflation in the calculations, which is much, much simpler. Unfortunately however, economic decisions are based upon ex-ante rates, not ex-post rates, and the use of the simpler to measure ex-post real rate is generally inappropriate. Is that one of the problems here?

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, an ex-post analysis will likely show a saving from the TIPS program.

So does that make ex-post analysis invalid?

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 bottom line, then, for ex-post studies?

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.

How do we answer this question?

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.

Obviously, we can't run the economy over and over and then average the outcomes, so what do we do?

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.

Let's get to the actual ex-ante analysis. I've heard about something called the breakeven inflation rate. What is that?

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 ex post; if inflation comes in below the breakeven rate, the investor who bought nominal securities wins.

What's the breakeven rate right now?

[When I last checked], 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.

Wow. Right on the money. What does this mean?

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.

So the cost of TIPS is about the same as other forms of financing?

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. ... 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 either way you measure it, ex-ante or ex-post, it's a close call with TIPS coming out slightly ahead?

But that’s before we have included some of the other considerable—although more difficult to quantify—benefits associated with TIPS issuance.

I see you have a long list detailing those benefits, the ones listed above with bullet points, and also ways to enhance these benefits, but we're running out of time so we'll have to leave that to the written version, apologies.

Hopefully, I have convinced you that the benefits of an ongoing TIPS program exceed its costs.

You've convinced me, you're quite the cheerleader. Do you have any further conclusions to share before we sign off?

Long live TIPS! That’s my conclusion.

Yes, well, thanks for talking.

    Posted by on Friday, December 14, 2007 at 12:33 AM in Budget Deficit, Economics, Inflation | Permalink  TrackBack (0)  Comments (10)


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