Treasury TIPS -- Treasury's Motivations

Perhaps the most contentious issue I had to deal with during my tenure at Treasury was the controversy over issuance of inflation-indexed bonds. It certainly was the longest lasting. Now a new paper ("Why Does the Treasury Issue TIPS? The TIPS-Treasury Bond Puzzle") by three professors at the UCLA Anderson School written for the National Bureau of Economic Research (Mattthias Fleckenstein, Francis A. Longstaff, and Hanno Lustig) argues that TIPS (Treasury Inflation-Protected Securities) are a costly form of finance and asks why the Treasury "leaves billions of dollars on the table by issuing securities that are not as highly valued by the market as nominal Treasury bonds." (A September 6 draft version of the paper is available for download here.)

When it comes to academics, Treasury just can't win on this issue. It was, after all, academic economists who were the loudest proponents of Treasury issuing the bonds. Proponents included such luminaries as James Tobin, Milton Friedman, and Stanley Fischer. Now that Treasury has been issuing TIPS for almost 14 years, Treasury is being attacked by academics for issuing these securities.

During the Reagan Administration, there was a big push by some Administration economists to get the Treasury to issue inflation-indexed securities. The Domestic Finance section of Treasury was consistently opposed. One senior political appointee joked that the way to market inflation-indexed bonds was to use the membership mailing list of the American Economic Association. Others at Treasury, though, were strong proponents, including Under Secretary for Monetary Affairs Beryl Sprinkel, to whom the Assistant Secretary for Domestic Finance reported (the organizational chart at Treasury has since changed.). However, even with that high level support for inflation-indexed bonds, the proponents were never able to convince the various Treasury Secretaries to issue this new type of security.  It is useful to remember that at the time of these debates, inflation had been high but was being brought under control.

In the George H.W. Bush Administration, the issue receded at Treasury even if academics wanted to pursue it. The political leadership of Domestic Finance at Treasury was just not interested. (Interestingly, Vice President Dan Quayle had been a proponent of inflation-indexed bonds as a Senator and raised the issue at a hearing of the Joint Economic Committee, but, as far as I know, he did not press the issue as Vice President.)

During the Clinton Administration, inflation-indexed bonds became a live issue again. Two strong proponents of inflation-indexed bonds were Larry Summers and Alicia Munnell, both of whom had an academic background. Fed Chairman Alan Greenspan was also a strong proponent. Secretary Rubin, reflecting the consensus view of the major government security dealers at the time, was initially dubious, but eventually he became convinced. The political leadership of Domestic Finance was more ambivalent about the issue than their predecessors had been, and, in any case, taking on Larry Summers is not something one does lightly. When it became clear that Rubin was likely to decide to issue inflation-indexed bonds, I began work on the technical details.

The case against inflation-indexed bonds was mainly based on doubts that they would be cost-effective from Treasury's point of view. Reason for these doubts included: (1) lesser liquidity than conventional Treasuries; (2) limited demand because the appreciation of principal would be taxed currently even though it was not paid out; and (3) no evidence that inflation indexation was something for which there was a lot of demand (efforts to issue price level adjusted mortgages had not been successful).

The proponents' main argument was that inflation-indexed bonds would be cost-effective because investors would be willing to pay up for the inflation insurance these securities offered. In addition, proponents said that the bonds would act as a "sleeping policeman," because Treasury's interest costs would soar on these securities if inflation got out of control. The bonds also could motivate the private market to come up with more inflation-indexed products, such as inflation adjusted annuities (though some, but not all, opponents viewed this as a drawback because it would reduce the size of the anti-inflation constituency.)  In addition, the bonds would provide both the market and policymakers information about inflation expectations which would lead to better decisions.

During the initial years of TIPS issuance, it was clear that the securities had not been cost-effective up to that point. There was always hope that as the market grew and became more liquid, the pricing Treasury received at its auctions would improve.

At this point, though, getting rid of TIPS would be difficult for Treasury to do. A surprise announcement, such as Peter Fisher's announcement of stopping the issuance of 30-year bonds, would not be good policy. Moreover, the Treasury has made numerous statements confirming its commitment to TIPS, and any sudden reversal of policy would be viewed as breaking faith with the market. For example, the sponsors and investors in TIPS mutual funds would be very unhappy if these securities were no longer issued.

While a gradual reduction of TIPS issuance is a possible policy course, I think that Treasury career staff would be hesitant to recommend major changes to the TIPS program on their own initiative, given what a hot potato this subject has been. In any case, I do not know if they agree with the UCLA authors that the program is currently an expensive form of financing. Any decision to review possible major changes in TIPS issuance would have to come from the political appointees. Even if they were inclined to reduce substantially or eliminate TIPS issuance, I think most political appointees would be hesitant to face the criticism that would be hurled at them on this particular issue.

If the authors of the NBER article are correct that TIPS continue to be expensive, there are reasons why Treasury is likely to continue with the program. What the authors do not discuss but is an interesting question is how TIPS will fare if the U.S. enters a long period where inflation is negligible. At the moment, even though there are deflation fears, there is also a concern about he eventual reemergence of inflation. No one knows if the fear of future inflation will lessen, but, if it does, that would certainly impact the TIPS market.