PrefBlog

William C Dudley, President and Chief Executive Officer of the Federal Reserve Bank of New York, gave a speech at the Federal Reserve Bank of New York Inflation-Indexed Securities and Inflation Risk Management Conference, New York on 10 February 2009.

He addressed the problems of ex-ante vs. ex-post calculations of the costs of TIPS issuance:

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.

… and examined the factors affecting TIPS pricing:

There are two primary factors underlying the relative cost differences:
1) the compensation investors require to hold a security that is less liquid than its nominal counterpart, termed the illiquidity premium, and
2) the insurance value they attach to obtaining protection against inflation risk, known as the inflation risk premium.

[footnote]In addition to these primary factors, TIPS yields also reflect the taxation difference between TIPS and nominal issues, the convexity difference between real and nominal yields and the price of the embedded deflation floor.

… and refers to some Fed analysis:

To determine the impact of the illiquidity premium and inflation risk premium on these results, we decomposed our ex-ante analysis, comparing the breakeven rate of inflation excluding the illiquidity premium in TIPS yields to the SPF forecast. This comparison yields an estimate of the premium investors were willing to pay for inflation protection at previous TIPS auctions. We found an average risk premium estimate of 47 basis points over our sample period. This suggests that the TIPS program does satisfy a real demand that is not met by nominal Treasuries.

It also suggests that if the Treasury were to take steps to shrink the illiquidity premium by, for example, improving secondary market trading in TIPS, this would shift the cost-benefit analysis more firmly in TIPS direction.

[Footnote] We used the illiquidity premium in TIPS yields estimated in D’Amico, Kim and Wei (2008). D’Amico, Kim and Wei calculated the liquidity component for five- and ten-year TIPS yields, which we used to adjust the auction prices for 5- and 10-year TIPS issues. For twenty- and thirty-year TIPS issues, we assumed that the liquidity component is equal to the component for a ten-year security, which in the event that these securities are less liquid than the ten-year note, understates this effect and thus underestimates the risk premium at this horizon. For further information, see Dudley, Roush and Steinberg Ezer (2008).

… and refers to some external studies of extremely hard to quantify benefits:

A few studies have found that an increase in supply in a particular segment of the Treasury yield curve has contributed to a rise in yields. As a result, by issuing securities in a segmented TIPS market, the Treasury may keep realized yields on bill and nominal coupon securities lower than they otherwise would have been.

and, importantly, hints at a process involving larger issues of longer dated TIPS:

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 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 investors pay for inflation protection increases as maturities lengthen.

Second, it may make sense to structure the TIPS program in a way that would help reduce the illiquidity premium associated with TIPS relative to on-the-run nominal Treasuries. Some of the current illiquidity premium is likely to shrink as financial markets stabilize. However, further improvements may require a change in either the structure of the TIPS program or the secondary market trading environment.

The notion that issuance of 5-Year TIPS might be halted has been discussed on PrefBlog, as has a BoE Working Paper on the term-structure of inflation indexed bonds.

This entry was posted on Sunday, February 15th, 2009 at 4:56 pm and is filed under Interesting External Papers. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.