FROM THE OFFICE OF PUBLIC AFFAIRS

Treasury is Committed to Inflation Indexed Securities

Good morning. It is a pleasure to have the opportunity to speak with you again. Yesterday, I tried to give you a feel for debt management at Treasury as well as our position in the marketplace. We talked about the regularity and predictability of Treasury debt management. I stressed that Treasury is not an opportunistic borrower. We believe a regular auction calendar will provide investors with certainty. That certainty will help translate into broader investor participation which will then help lower Treasury’s borrowing costs.

We also seek to lower Treasury’s borrowing by increasing the pool of potential investors. Which leads me to today’s topic: inflation indexed securities, or TIIS.

If there is one message I want you to take away from my presentation today, it is that we are committed to the TIIS market. This commitment is based on sound debt management principles. By broadening our investor base and diversifying our funding sources, we reduce our borrowing costs over time. By diversifying our types of borrowing, we reduce exposure to a single adverse shock.

We believe that TIIS are a different asset class. As more and more investors accept this distinction, growth of the TIIS market has been accelerating. Many investors have had huge success with TIIS as a tactical allocation. Some have had even greater success with TIIS as a strategic allocation. I believe that for many investors and money mangers a percentage of their portfolios should be focused on real rather than nominal rates of return. The market is still quite young—essentially five years old—and it is still evolving. In fact, a year or two ago, there were concerns that the TIIS program was in jeopardy. I am here to put those fears to rest. Even with a return to surpluses, we are committed to the TIIS program.

I just said that TIIS represent a different asset class, but that does not mean we manage them differently. We issue TIIS the same way we do nominal bonds. At Treasury, we are committed to issuing large, liquid securities. We announced a new TIIS policy in May of this past year. We increased the number of 10-year note auctions from two to three. We now auction a new security in July and reopen it in both October and January. Reopenings can sometimes cost Treasury money because we do not capture the on-the-run premium often associated with new issuance. However, the benefits of large and predictable issuance – a more stable and liquid secondary market – outweigh the cost of reopening.

We considered several options before we announced our current issuance program [the high amount of TIIS maturing in July and the value in reopening securities over six rather than twelve months]. However, it is important that we expand the auction calendar without moving too fast and getting ahead of the market.

One point on this slide that I want to highlight is the deflation protection. Principal is guaranteed at maturity. That is not a comment on interest rates but it is an option that does have some value.

Our commitment to TIIS is also evident in our issuance. We have become the world’s largest IIS issuer with more than $150 billion outstanding. However, at this point we do plan to target our issuance as a percentage of gross issuance. Even though we strive to be regular and predictable, we can not limit our flexibility as debt managers by committing to specific issuance in the future. On the margin, factors beyond my control, such as outlays and receipts, determine our borrowing needs.

A much higher percentage of auction awards are allocated to investment funds, a further indication that the market has come to believe that we are committed to TIIS. Though I have no empirical evidence to support this, I believe many of these investors view TIIS as a tactical as well as a strategic investment.

Increased issuance and greater market acceptance has led to increased liquidity. TIIS may never trade with the liquidity of nominal Treasuries, but that may not be the appropriate standard – by any other measure, liquidity is good and promises to get better. I also believe many dealers are committing more capital TIIS. Until Treasury publicly announced commitment to TIIS, I think the dealers were a little wary of committing personnel and capital. I am excited at the prospects for the dealer community.

Over the 5 years we have been issuing inflation-indexed securities, some analysts have said they are a more expensive form of borrowing than the comparable nominal securities. It’s too early to pass judgment on the cost effectiveness of these instruments. It takes time and effort to build a critical mass of liquidity.

Diversifying our investor base may be the most important contribution of TIIS, but I believe that over time they will be viewed as cost-effective. We are a long way from making that assessment – at a minimum, cost-effectiveness should only be determined after a product has been through an entire interest rate cycle. Even then I think we have to be careful how to judge TIIS. The market does not judge, for example, whether or not 3-month bills are more expensive to issue than 5-year notes over time. Market participants recognize that Treasury is diversifying its investor base and its exposure to adverse interest rate movements.

The decision to invest is yours and I do not want to encourage an investment that may or may not be appropriate for you. But I do want to point out a few things. These securities are of particular value to investors because their prices move differently from conventional securities. As you can see they have lower risk than the Lehman index and 10-year note, both absolute and relative. Their real (inflation unadjusted) price varies inversely with real U.S. interest rates, not nominal interest rates, making them very attractive for risk diversification. We also think that Treasury Inflation-Indexed Securities are a unique asset class – dollar-denominated, inflation- protected, backed by U.S. full faith and credit – that every diversified investor should own.

Investors should also find the scale of TIIS attractive. Comparably sized markets include global high yield debt, emerging market securities, and European corporates. In comparison, the inflation-indexed market is highly liquid due to the quality of the issuers, large issuance sizes and broad range of maturities.

We believe there is and will be strong demand for inflation protected notes backed by the full faith and credit of the US Government. We are excited about the growth prospects for TIIS. I would like to encourage everyone here to contact Treasury or myself should you have any suggestions in how to grow this asset class.

Thank you very much. I would be happy to take any questions