In January 1997, Treasury introduced its  own inflation-indexed securities, TIPS, as part of its debt program. At the  time, Treasury’s stated objectives for introducing TIPS were both to raise  the national savings rate and to reduce the federal government’s cost of  borrowing. TIPS offer inflation protection to investors who are willing to  pay a premium for this protection in the form of a lower interest rate. In a  functioning TIPS market, the difference between the interest rate on  nominal Treasury securities and the interest rate on TIPS should  approximately equal the expected inflation rate. To examine what role TIPS should play in Treasury’s debt portfolio and  the potential for the TIPS program to help address Treasury’s debt  management challenges, we conducted literature reviews on the costs and  benefits of inflation-indexed securities and examined research by Federal  Reserve economists, market experts, academic sources, and the  Department of the Treasury, including an internal review of the TIPS  program done by the Office of Debt Management (ODM). Treasury’s total outstanding debt  increased by $2.3 trillion (25 percent increase in federal debt) since the  onset of the economic recession in December 2007. The largest increase in outstanding marketable Treasury  securities was in short-term debt. Fiscal Outlook Will Present Continued Debt Management Challenges

As noted, the federal government’s policy response to the financial market  crisis and the economic recession created a significant increase in both  debt and debt management challenges. These will not recede when  stability returns to financial markets and economic growth resumes. CBO  projects that, absent changes in current policy, the debt held by the public  will double in 5 years (from 2008 to 2013) and almost triple in 11 years  (from 2008 to 2019). Treasury’s TIPS Program Has Had Varying Degrees of Liquidity Since Inception and Major Institutional Investors Have Expressed Concern about Treasury’s Commitment to the Program

Treasury’s TIPS program has had varying degrees of liquidity since its  inception in 1997. Liquidity is a measure of the ease with which investors  can trade a security. TIPS Program Offers Benefits to Treasury, and Measuring Its Cost Requires both Forward-Looking and After-the-Fact Analysis

TIPS offer a variety of benefits to both Treasury and investors. TIPS Program Could Benefit Treasury by Diversifying Its Funding Sources and Investor Base

TIPS could benefit Treasury by diversifying its funding sources and  investor base. Economists have noted that governments are better able to bear inflation  risk because periods of inflation are often associated with increased  revenues. The  results of TIPS auctions also provide useful information to policymakers  on inflation expectations. On July 1, 2009, we briefed Treasury’s ODM on the findings from our  analysis and interviews with major institutional investors. Treasury later  posed questions about ways to improve the TIPS program to the Primary  Dealers and TBAC. At the August 2009 TBAC meeting, members discussed  TIPS. Following the meeting, Treasury’s Deputy Assistant Secretary for  Federal Finance reaffirmed Treasury’s commitment to TIPS and  announced plans to gradually increase issuance of TIPS. The Secretary should continually review the appropriate composition of  the TIPS program, and consider:  the impact of Treasury’s public statements and TIPS issuances on TIPS  liquidity,    how both ex-ante (before the fact) and ex-post (after the fact) analyses  are valuable for evaluating the cost of TIPS, recognizing the anomalous  nature of market data from periods such as the 2008 financial market  crisis,  the ways in which the TIPS program can diversify Treasury’s investor  base and funding sources, and  the degree to which TIPS impact the cost of nominal securities.
Why GAO Did This Study

The 2008 financial market crisis and the economic recession led to a rapid and substantial increase in federal debt. This report, part of a line of work on debt management, was conducted under the Comptroller General's authority. It describes current debt management challenges and examines the role of a program that could benefit Treasury--Treasury Inflation Protected Securities (TIPS). GAO analyzed market data and interviewed experts as well as the two largest holders of Treasury securities in each of six sectors.

What GAO Found

In January 1997, Treasury introduced an inflation-indexed security--TIPS. Treasury's stated objectives were to both raise the national savings rate and to reduce the federal government's cost of borrowing. TIPS offer inflation protection to investors who are willing to pay a premium for this protection in the form of a lower interest rate. In a functioning TIPS market, the difference between the interest rate on nominal Treasury securities and the interest rate on TIPS is expected to be approximately equal to the expected inflation rate. Federal government actions in response to both the financial market crisis and the economic recession have added significantly to Treasury's borrowing needs. Since the onset of the recession in December 2007, Treasury has borrowed more than $2.3 trillion, largely by issuing short-term nominal debt, which significantly changed the composition of Treasury's debt portfolio. The challenges presented by increasing debt and the change in its composition take place in the context of the medium and longer term fiscal outlook and will not recede with the return of financial market stability and economic growth. The Congressional Budget Office (CBO) projects that, absent changes in current policy, debt held by the public will double in 5 years (from 2008 to 2013) and almost triple in 11 years (from 2008 to 2019)--reaching 82 percent of GDP. In order to meet these challenges Treasury needs to diversify its funding sources and lengthen the term-to-maturity of its debt portfolio. TIPS can contribute to this effort. Treasury's TIPS program has had varying degrees of liquidity (the ease with which investors can trade the security) since its inception. The major institutional investors that GAO interviewed perceived Treasury's commitment to the TIPS program as having wavered in recent years, decreasing the liquidity of TIPS in the market. Investors demand a premium for holding less-liquid TIPS, which increases Treasury's borrowing costs. TIPS offer benefits to Treasury and measuring the cost against which to weigh these benefits requires both forward-looking and after-the-fact analysis. A more robust TIPS program could benefit Treasury by diversifying and expanding its funding sources and reducing the cost of nominal securities. Governments are well suited to bear inflation risk because periods of inflation are often associated with increased revenues. TIPS auctions also help provide a measure of market inflation expectations. On July 1, 2009, GAO briefed Treasury's Office of Debt Management on the findings from our analysis and interviews with major institutional investors. Treasury later posed questions about ways to improve the TIPS program to the Primary Dealers and the Treasury Borrowing Advisory Committee (TBAC). At the August 2009 TBAC meeting, members discussed TIPS. Following the meeting, Treasury's Deputy Assistant Secretary for Federal Finance reaffirmed Treasury's commitment to TIPS and announced plans to gradually increase issuance of TIPS.