There has been some comment about the negative yield realized on the October 25 auction of 41/2 year Treasury Inflation Protected Securities (a reopening of a security originally issued with a maturity of 5 years.) Excluding accrued interest, winning bidders paid $105.508607 for an original par value of $100 of the security.
Most commentary said that, based on the spread between the negative yield on this security with conventional Treasury securities in the five-year maturity area, this implied that market participants believe that inflation will be increasing.
I did not see any commentary that mentioned that TIPS also provide more real yield under certain circumstances when there is deflation. I discussed this in a previous post. In short, purchasers of TIPS are assured of getting $100 back at maturity for an original par value of $100 in the event of deflation over the life of the security.
Given the index ratio of 1.00725 for the issue date of the reopened securities, deflation would have to run at an average annual rate of more than approximately -0.16% for the next 4 1/2 years for Treasury to be required to pay a supplement to the adjusted value of the principal at maturity. Any supplement payment would mean that the negative real yield of the TIPS would be reduced, and, if deflation were severe enough, the realized real yield could become positive.
Thursday, October 28, 2010
Wednesday, October 27, 2010
New Information on the CFTC Administrative Law Judge Mess
Michael Hiltzik has a column in the Los Angeles Times about CFTC Administrative Law Judge Painter, which advances the CFTC ALJ story.
Hiltzik says he has spoken with Painter and found him “perfectly lucid.” He also writes that “Douglas Painter, a Los Angeles attorney [and Judge Painter's son], contends that Ritter overmedicated his father in preparation for the Alzheimer's tests and tried to isolate him from his friends and family, and that no one else has reported seeing the symptoms in his father that Ritter [his wife] reports.”
While Hiltzik effectively admits to being an admirer of Painter because of his actions in the past, he also presents Elizabeth Ritter’s side of the story. “She [Ritter] says Painter's son, Douglas, and other relatives improperly removed him from the center, got him a lawyer to file for divorce, and have kept him on the move cross-country to keep him isolated and disoriented.” Hiltzik also quotes her lawyer, Kim Viti Fiorentino as saying, “Elizabeth just wants what's best for him to protect his well-being and his dignity.” According to the article, Painter’s lawyer said in response to that: “He's in full control of his affairs, and if he needs assistance he can make his own choices.”
From this, we can infer that Painter is probably in the Los Angeles area. Also, this family law case complicates an already messy situation at the CFTC, given Painter’s charges against the other CFTC ALJ, Bruce Levine.
Some think that the CFTC will do its best to sweep this under the rug. For example, see this post at the Seeking Alpha website.
Evidence that the CFTC wants this to go away is on the agency’s website. The CFTC has issued an order transferring six of the seven reparation cases that Painter wanted assigned to an ALJ from another agency to Bruce Levine. The order states that Painter “lacks authority to make this unusual request.” (It is not clear from the document what will happen or has happened to the seventh case Painter wanted reassigned to an outside ALJ -- An Li v. Forex Capital Market, LCC, 09-R054.)
While press coverage of this issue has been spotty, it seems likely that it will not go away as quietly as some might want. At a minimum, lawyers involved in CFTC reparation cases may want to raise questions about either Levine or Painter if they believe it serves their clients' interests. In this connection, Hiltzik writes: “Steven Berk, an investor protection attorney in Washington, says, ‘It's an open secret among my brethren that if you get Levine, he's not going to rule for the investor.’”
In addition, some in Congress may want to look into this matter, and some CFTC commissioners may not be all that happy with Levine. For example, Hiltzik notes that, in 2007, “the CFTC concluded that Levine committed ‘procedural errors’ and ‘severely prejudiced’ an investor in his $74,000 complaint against a futures broker. The commission awarded the investor more than $32,000.”
Hiltzik says he has spoken with Painter and found him “perfectly lucid.” He also writes that “Douglas Painter, a Los Angeles attorney [and Judge Painter's son], contends that Ritter overmedicated his father in preparation for the Alzheimer's tests and tried to isolate him from his friends and family, and that no one else has reported seeing the symptoms in his father that Ritter [his wife] reports.”
While Hiltzik effectively admits to being an admirer of Painter because of his actions in the past, he also presents Elizabeth Ritter’s side of the story. “She [Ritter] says Painter's son, Douglas, and other relatives improperly removed him from the center, got him a lawyer to file for divorce, and have kept him on the move cross-country to keep him isolated and disoriented.” Hiltzik also quotes her lawyer, Kim Viti Fiorentino as saying, “Elizabeth just wants what's best for him to protect his well-being and his dignity.” According to the article, Painter’s lawyer said in response to that: “He's in full control of his affairs, and if he needs assistance he can make his own choices.”
From this, we can infer that Painter is probably in the Los Angeles area. Also, this family law case complicates an already messy situation at the CFTC, given Painter’s charges against the other CFTC ALJ, Bruce Levine.
Some think that the CFTC will do its best to sweep this under the rug. For example, see this post at the Seeking Alpha website.
Evidence that the CFTC wants this to go away is on the agency’s website. The CFTC has issued an order transferring six of the seven reparation cases that Painter wanted assigned to an ALJ from another agency to Bruce Levine. The order states that Painter “lacks authority to make this unusual request.” (It is not clear from the document what will happen or has happened to the seventh case Painter wanted reassigned to an outside ALJ -- An Li v. Forex Capital Market, LCC, 09-R054.)
While press coverage of this issue has been spotty, it seems likely that it will not go away as quietly as some might want. At a minimum, lawyers involved in CFTC reparation cases may want to raise questions about either Levine or Painter if they believe it serves their clients' interests. In this connection, Hiltzik writes: “Steven Berk, an investor protection attorney in Washington, says, ‘It's an open secret among my brethren that if you get Levine, he's not going to rule for the investor.’”
In addition, some in Congress may want to look into this matter, and some CFTC commissioners may not be all that happy with Levine. For example, Hiltzik notes that, in 2007, “the CFTC concluded that Levine committed ‘procedural errors’ and ‘severely prejudiced’ an investor in his $74,000 complaint against a futures broker. The commission awarded the investor more than $32,000.”
Wednesday, October 20, 2010
CFTC Administrative Law Judge Developments -- It 's Getting Nasty
Sarah N. Lynch of Dow Jones Newswire has a story today that begins: “An administrative law judge [Judge George H. Painter] at the Commodity Futures Trading Commission heard and decided cases during a period when his wife said he struggled with mental illness and alcoholism, court records show.” (The WSJ Online version can be found here. Subscription is probably required, but you can use Google News to search for information about CFTC ALJs.)
According to the article, Judge Painter is seeking to divorce his wife, Elizabeth Ritter, a long-term CFTC lawyer. She is seeking to be Judge Painter's guardian, but Painter's son and a niece are contesting this. The article states that the son and niece said in legal filings that "the judge doesn't exhibit the mental problems described in court records by his wife. Judge Painter's lawyer, Ms. Galloway Ball, said he intends to fight the guardianship case."
From what is now on the public record, the CFTC clearly has a big problem. Now that a reporter has apparently been steered to search court records involving a severe family dispute at the same time that Judge Painter's accusations concerning another ALJ's bias have become public, it seems probable we will learn more.
According to the article, Judge Painter is seeking to divorce his wife, Elizabeth Ritter, a long-term CFTC lawyer. She is seeking to be Judge Painter's guardian, but Painter's son and a niece are contesting this. The article states that the son and niece said in legal filings that "the judge doesn't exhibit the mental problems described in court records by his wife. Judge Painter's lawyer, Ms. Galloway Ball, said he intends to fight the guardianship case."
From what is now on the public record, the CFTC clearly has a big problem. Now that a reporter has apparently been steered to search court records involving a severe family dispute at the same time that Judge Painter's accusations concerning another ALJ's bias have become public, it seems probable we will learn more.
Regulatory Capture? -- A CFTC Administrative Law Judge Accuses
This morning there is a rather amazing article in the Washington Post about a retiring CFTC administrative law judge accusing the one other ALJ of bias against complainants. In a Notice and Order dated September 17, 2010, ALJ George H. Painter recommends that seven reparation cases currently before him not be reassigned to the other CFTC ALJ, Bruce Levine.
Regarding Levine, Painter writes: “On Judge Levine's first week on the job, nearly twenty years ago, he came into my office and stated that he had promised Wendy Gramm, then Chairwoman of the Commission, that we would never rule in a complainant's favor. A review of his rulings will confirm that he has fulfilled his vow.”
Futures Magazine has posted the document online. It includes as an attachment a December 13, 2000 Wall Street Journal article by reporter Michael Schroeder about charges that Judge Levine was biased against complainants -- “If You've Got a Beef With a Futures Broker, This Judge Isn't for You -- In Eight Years at the CFTC, Levine Has Never Ruled In Favor of an Investor.” (The Futures Magazine article on this can be found here.)
All this raises some questions. Why did Judge Painter take this long to come forward, or did he do so in the past, but this is the first time his accusation has become public? Why did the CFTC do nothing about the accusations of bias detailed in the WSJ article?
To be fair to the CFTC, ALJ's have some protections and insulation from the heads of the agency they work for, and I am not sure what the CFTC can do. The Commission apparently can seek to have Levine removed at a hearing before another ALJ working for the Merit System Protection Board, but that probably requires a high standard of proof.
In addition to deciding what to do about the seven cases currently assigned to Painter, one assumes the CFTC will determine that it needs to figure out how to restore the credibility of its reparation program.
Regarding Levine, Painter writes: “On Judge Levine's first week on the job, nearly twenty years ago, he came into my office and stated that he had promised Wendy Gramm, then Chairwoman of the Commission, that we would never rule in a complainant's favor. A review of his rulings will confirm that he has fulfilled his vow.”
Futures Magazine has posted the document online. It includes as an attachment a December 13, 2000 Wall Street Journal article by reporter Michael Schroeder about charges that Judge Levine was biased against complainants -- “If You've Got a Beef With a Futures Broker, This Judge Isn't for You -- In Eight Years at the CFTC, Levine Has Never Ruled In Favor of an Investor.” (The Futures Magazine article on this can be found here.)
All this raises some questions. Why did Judge Painter take this long to come forward, or did he do so in the past, but this is the first time his accusation has become public? Why did the CFTC do nothing about the accusations of bias detailed in the WSJ article?
To be fair to the CFTC, ALJ's have some protections and insulation from the heads of the agency they work for, and I am not sure what the CFTC can do. The Commission apparently can seek to have Levine removed at a hearing before another ALJ working for the Merit System Protection Board, but that probably requires a high standard of proof.
In addition to deciding what to do about the seven cases currently assigned to Painter, one assumes the CFTC will determine that it needs to figure out how to restore the credibility of its reparation program.
Tuesday, October 12, 2010
Some Further Thoughts on "QE2"
Those who believe that the economy needs more stimulus are worried because the likelihood of it coming from fiscal policy in the near-term seems unlikely. Laurence Myer in his presentation this weekend said that, since the Fed has reached its lower bound of zero on the fed funds rate, it is time for fiscal stimulus. That, though, seems politically impossible. He went on to say that, if the Fed wants to lower longer-term Treasury yields, it can either choose a quantity of Treasury notes and bonds to buy or target a specific yield for Treasury 10-year rates. The second option is more risky for the Fed; it loses control of its balance sheet because it does not know the amount of securities it needs to buy in order to hit its target.
Also, I would note that, as the Fed buys massive amounts of Treasury notes and bonds, market participants may worry about future inflation. In other words, while the Fed may reduce the supply of Treasury notes and bonds, demand for them may also fall. The Fed will not likely want to end up owning all the Treasury 10-year notes. If it did, what would be the price of private debt obligations in the absence of a Treasury reference yield?
An alternative, of course, is for the Fed to buy private securities in order to reduce the spread between them and Treasuries, but this also raises issues, such as selection and potential charges of favoritism. It would also contribute to the decline in the quality of the assets the Fed holds.
Mr. Myer concluded that, if the Fed's policy of increasing its balance sheet does not work and unemployment continues to rise, there will be fiscal stimulus. It would be different than the first stimulus, since Republicans more partial to tax cuts will have more say. He suggested one possibility might be a payroll tax holiday.
I agree that, if the unemployment rate increases, additional fiscal stimulus will ultimately be undertaken. Whatever their ideologies or economic beliefs (Ricardian equivalence?), politicians will heed the calls for the government to do something if the economy worsens.
I was somewhat surprised at the pessimism I heard from the people in the financial sector who descended on Washington last week and were here through the weekend. The possibility of a slow recovery seems to be discounted, but that may be what happens. One reason for the pessimism of this international crowd is the specter of currency wars, and that is indeed worrying.
Another reason to worry, but the international bankers seemed less focused on it, is the U.S. foreclosure crisis. There has been an amazing disregard for the importance of state laws governing transferring of ownership of real estate in the securitization of mortgages. How this will be resolved is at this point uncertain, but financial intermediaries are likely to be hurt.
In any case, Keynes' "animal spirits" were hard to find among the international financial sector representatives in Washington last week. Will a new dose of quantitative easing fix that or cause more anxiety?
Also, I would note that, as the Fed buys massive amounts of Treasury notes and bonds, market participants may worry about future inflation. In other words, while the Fed may reduce the supply of Treasury notes and bonds, demand for them may also fall. The Fed will not likely want to end up owning all the Treasury 10-year notes. If it did, what would be the price of private debt obligations in the absence of a Treasury reference yield?
An alternative, of course, is for the Fed to buy private securities in order to reduce the spread between them and Treasuries, but this also raises issues, such as selection and potential charges of favoritism. It would also contribute to the decline in the quality of the assets the Fed holds.
Mr. Myer concluded that, if the Fed's policy of increasing its balance sheet does not work and unemployment continues to rise, there will be fiscal stimulus. It would be different than the first stimulus, since Republicans more partial to tax cuts will have more say. He suggested one possibility might be a payroll tax holiday.
I agree that, if the unemployment rate increases, additional fiscal stimulus will ultimately be undertaken. Whatever their ideologies or economic beliefs (Ricardian equivalence?), politicians will heed the calls for the government to do something if the economy worsens.
I was somewhat surprised at the pessimism I heard from the people in the financial sector who descended on Washington last week and were here through the weekend. The possibility of a slow recovery seems to be discounted, but that may be what happens. One reason for the pessimism of this international crowd is the specter of currency wars, and that is indeed worrying.
Another reason to worry, but the international bankers seemed less focused on it, is the U.S. foreclosure crisis. There has been an amazing disregard for the importance of state laws governing transferring of ownership of real estate in the securitization of mortgages. How this will be resolved is at this point uncertain, but financial intermediaries are likely to be hurt.
In any case, Keynes' "animal spirits" were hard to find among the international financial sector representatives in Washington last week. Will a new dose of quantitative easing fix that or cause more anxiety?
Monetary Policy and Treasury Debt Management -- A New Operation Twist?
In reaction to economic weakness and little likelihood in the near-term of any significant fiscal stimulus, the Federal Reserve seems ready to buy a significant amount of longer-term Treasury securities. This has been popularly called "QE2" -- a second round of quantitative easing -- with some no doubt enjoying that this name sounds more like a luxury ocean liner than a policy.
In a speech at a conference sponsored by Deutsche Bank this weekend in Washington, DC coinciding with the World Bank/IMF annual meetings, former Fed governor Laurence Myer said that calling the likely new policy quantitative easing was somewhat misleading -- reserve creation (increase in Fed liabilities) is just a by-product of the Fed increasing the asset side of its balance sheet. I think his point is that, since banks are sitting on a significant amount of excess reserves, the reserve creation is secondary to the effort to decrease longer-term Treasury yields.
Another former Federal Reserve governor (and vice chairman), Alan Blinder, in an appearance on Sunday at the annual meeting of the Institute of International Finance in Washington said that there might be tension between debt management and a Fed policy of buying longer-term Treasury securities.
Indeed there might. Mr. Blinder indicated that if he were in Secretary Geithner's shoes, he might want to issue more long-term Treasury securities in light of low interest rates and that this could result in a "Mexican standoff" between the Fed and the Treasury. In fact, as I discussed in a previous post, the Treasury has already reversed the shortening strategy of both the Clinton and George W. Bush Administrations and is lengthening the average maturity of the public debt.
We have seen this before. In the early 1960s, the Treasury and the Fed embarked on "Operation Twist." The desire was to increase short-term interest rates to protect the dollar in the foreign exchange markets and to lower long-term interest rates in order to promote economic growth. The idea was that both Fed open market operations and Treasury debt management would be conducted to increase the supply of T-bills in the market and reduce the amount of longer-term debt. The result of this exercise was, at best, inconclusive. There is some question how hard Treasury tried to play its part, since the average maturity of the public debt after briefly declining started increasing.
At some point under the likely new Fed initiative, Treasury may think it is losing control of debt management policy, especially if the Fed purchases in the neighborhood of a trillion dollars of Treasury notes and bonds. While the Treasury will control what it issues to finance the government, it will be ceding to the Fed the authority to determine the quantity of long-term debt in private hands unless it tries to undo the Fed's policy. (For this purpose, though the Federal Reserve banks are technically private, they are really part of the government, and the interest they earn on Treasury securities above the amount the Federal Reserve System needs for expenses -- including paying interest on reserves -- is remitted to Treasury.) Also, when the Fed at some future date decides the time has come to shrink its balance sheet, the sale of Treasury securities will complicate Treasury's debt management.
The Fed, while not shy about giving the rest of the government advice, resists any statements or advice from the Administration on monetary policy. In this case, though, one hopes that there is close consultation between the Fed and the Treasury since a core function of Treasury is impacted. The Mexican standoff that Blinder worries about should be avoided.
Finally, whether or not the new Fed policy will work, even if the Treasury cooperates, is an open question.
In a speech at a conference sponsored by Deutsche Bank this weekend in Washington, DC coinciding with the World Bank/IMF annual meetings, former Fed governor Laurence Myer said that calling the likely new policy quantitative easing was somewhat misleading -- reserve creation (increase in Fed liabilities) is just a by-product of the Fed increasing the asset side of its balance sheet. I think his point is that, since banks are sitting on a significant amount of excess reserves, the reserve creation is secondary to the effort to decrease longer-term Treasury yields.
Another former Federal Reserve governor (and vice chairman), Alan Blinder, in an appearance on Sunday at the annual meeting of the Institute of International Finance in Washington said that there might be tension between debt management and a Fed policy of buying longer-term Treasury securities.
Indeed there might. Mr. Blinder indicated that if he were in Secretary Geithner's shoes, he might want to issue more long-term Treasury securities in light of low interest rates and that this could result in a "Mexican standoff" between the Fed and the Treasury. In fact, as I discussed in a previous post, the Treasury has already reversed the shortening strategy of both the Clinton and George W. Bush Administrations and is lengthening the average maturity of the public debt.
We have seen this before. In the early 1960s, the Treasury and the Fed embarked on "Operation Twist." The desire was to increase short-term interest rates to protect the dollar in the foreign exchange markets and to lower long-term interest rates in order to promote economic growth. The idea was that both Fed open market operations and Treasury debt management would be conducted to increase the supply of T-bills in the market and reduce the amount of longer-term debt. The result of this exercise was, at best, inconclusive. There is some question how hard Treasury tried to play its part, since the average maturity of the public debt after briefly declining started increasing.
At some point under the likely new Fed initiative, Treasury may think it is losing control of debt management policy, especially if the Fed purchases in the neighborhood of a trillion dollars of Treasury notes and bonds. While the Treasury will control what it issues to finance the government, it will be ceding to the Fed the authority to determine the quantity of long-term debt in private hands unless it tries to undo the Fed's policy. (For this purpose, though the Federal Reserve banks are technically private, they are really part of the government, and the interest they earn on Treasury securities above the amount the Federal Reserve System needs for expenses -- including paying interest on reserves -- is remitted to Treasury.) Also, when the Fed at some future date decides the time has come to shrink its balance sheet, the sale of Treasury securities will complicate Treasury's debt management.
The Fed, while not shy about giving the rest of the government advice, resists any statements or advice from the Administration on monetary policy. In this case, though, one hopes that there is close consultation between the Fed and the Treasury since a core function of Treasury is impacted. The Mexican standoff that Blinder worries about should be avoided.
Finally, whether or not the new Fed policy will work, even if the Treasury cooperates, is an open question.
Thursday, September 23, 2010
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.
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.
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