FROM THE OFFICE OF PUBLIC AFFAIRS

DEPUTY TREASURY SECRETARY LAWRENCE H. SUMMERS

TIAA/CREF

WASHINGTON, DC

It is a pleasure to be here before a group that plays such an important role in the markets for government securities and one that controls my pension. Today, I would like to begin by discussing the implications of lowerdeficits and the balanced budget agreement for Treasury's overall borrowing program. Iwould then like to offer some comments on our experience with inflation-indexed securitiesso far and our expectations for that program going forward.

Over the last four and a half years, the Clinton Administration's focus on reducing the deficit, a new bi-partisan consensus on theneed for fiscal responsibility, and a firm economy have combined to dramatically reducebudget deficits. Earlier this year in its Mid-Session Review of the FY 1998 budget, the Office of Management and Budget estimated a decline in the deficit to just $37 billion infiscal 1997, the smallest deficit as a percent of GDP since 1974.

Looking ahead, the prospect is forfurther reductions and even surpluses in the government's accounts. The balanced budget agreement,signed by the President on August 6, was a substantial step in the right direction.Without the agreement, OMB estimates that the deficit would have risen next year to $50 to$100 billion and stayed at that level for years to come. With it, OMB anticipates asurplus of $63 billion in FY2002 and continuing surpluses for several years thereafter.

The deficit reduction we haveaccomplishedis already putting less pressure on credit markets. In fact, assuming we maintain ourrecent pace of issuance of coupon securities, we will actually sell slightly less new,long-term debt in the next fiscal year than will mature. And the introduction of indexedsecurities implies that the reduction in supply of nominal coupon securities will be quitenoticeable--a 14 percent reduction compared with 12 months ago.

After decades of offering plain vanillasecurities to the market, the Treasury announced in the spring of 1996 that we would beginselling inflation-indexed securities. Other countries including Great Britain, Australiaand Canada had successfully issued inflation-protected securities. We were attracted tothem by their ability to stabilize both debt payments by the government and debt receiptsof investors, thus offering benefits to participants on both sides of the transaction.

Besides carefully studying the matterourselves, we talked to many participants across the country and abroad to secure theirinsight into the features that would be most attractive to investors. The investmentmanagers from TIAA-CREF were of particular help in this effort.

As a result of this research, when weoffered the first 10-year inflation-indexed notes in January, we were confident that thesecurities would be well received. And, in fact, demand at that first auction was sostrong that we took some bad press when demand was merely strong the next two times wewent to market.

We reopened the 10-year indexed notesinApril, and in July, we auctioned 5-year inflation-indexed notes for the first time,bringing the total sold to the public to $23.2 billion for the three auctions we have heldto date. Reflecting strong demand, in all three auctions, the price of the securities rosesomewhat in when-issued trading immediately following the auction.

In light of this positive experience,Treasury is committed to including inflation-indexed securities as part of our regulardebt management program. By the end of next year, we plan to establish a regular calendarof new 5-, 10-, and 30-year inflation-indexed security issues. Broader coverage across thematurity spectrum and along the yield curve will provide better hedging opportunities forprivate issuers, a broader range of choice for investors, and a better picture ofinflation expectations. The Treasury will also begin issuing inflation-indexed US SavingsBonds early next year.

With three auctions of inflation indexedsecurities and about nine months of market trading behind us, it is appropriate to givethe program its first report card. Although it is the market that, in one sense,ultimately gives the grades, as a former university professor I would like to summarizeits findings. For both investors and for the government, the inflation-indexed securitiesprogram has been highly successful.

Investors of all descriptions now have away to hedge themselves against inflation, either directly through purchases of the newsecurities or indirectly through mutual funds, retirement plans or insurance policies thatmake use of the new securities. Several mutual funds have been established that investprimarily in indexed securities, including one by TIAA-CREF. A number of other portfoliomanagers have purchased indexed securities to diversify their investment holdings. Alltold, more than $2 billion of additional inflation linked debt has been issued by avariety of non-Treasury borrowers, including a few municipal governments, several agenciesof the Federal government, some financial corporations and even a foreign borrower! TheChicago Board of Trade has also listed futures contracts and options on futures for 5-and10-year inflation-indexed notes.

It is clear that we have succeeded inestablishing a viable indexed instrument that offers investors an opportunity to diversifytheir portfolios. As the baby boomers begin to retire, I expect the ability to guarantee afixed level of purchasing power at a future date to be even more in demand.

As an issuer of the securities, Treasuryis also happy with the program. We have established a program that, over the years, willcost the government and the taxpayers less than nominal debt. This will result from thegovernment, instead of investors, taking the risk of inflation. In brief, we will receivethe inflation risk premium instead of paying it. And we can bear the risk of inflationmore efficiently than can any single investor, no matter how large.

The prices and yields on indexedsecurities have not moved in lock-step with fixed rate securities in recent months: atvarious times they have outperformed and underperformed fixed rate securities. On balance,while exhibiting less volatility, they have underperformed their conventional cousinsbecause inflation news has been more favorable than the market had expected. Thatcorresponds to lower returns, ex post, for investors and lower debt servicing costs, thusfar, for the government. This relation would be reversed if the news on inflation everturns less favorable than expected. That is not the whole story, however. We thinkinvestors should look at the choice between fixed-rate and indexed securities on arisk-adjusted basis. Investors give up some yield on an indexed security in return forinflation protection.

Some observers have commented on therelatively low trading volume and greater liquidity risk of indexed securities, comparedwith on-the-run nominal Treasury securities. Although the features of the indexedsecurities differ markedly from their fixed-rate cousins and the size of the issues areconsiderably smaller, trading volume does appear to be low. While I would not want tohazard a final pronouncement on this point, part of the answer may be that Treasury hasdiscovered a security that investors actually want to buy and hold.

The key questions fromTreasury’sperspective are whether the securities are being distributed to a wide spectrum ofinvestors and whether investors who hold the securities are comfortable with theirpositions. The answer to both of these questions is yes. The primary dealer community hasbeen awarded between half and two-thirds of each of the three auctions to date. Thisproportion compares with awards of three-quarters or more of each auction of fixed-ratecoupon securities and indicates that, on original issue, the indexed securities have beendistributed more widely. In contrast to some press reports, our best information is thatdealers have sold their inventories of the indexed securities in a timely way after theauctions.

Our review of trading in indexedsecurities using GOVPX data on the interdealer broker market indicates that volume isconcentrated in the when-issued trading period around the time of an auction --the daybefore and the day of the auction and during the period prior to settlement. It isinteresting to note that interdealer trading in the 10-year inflation security increasedat the time of the auction of 5-year indexed notes in July. We also understand fromanecdotal information that sales of the securities to professional portfolio managers andother non-dealer accounts are focussed in the when-issued periods. While it may not be aseasy to execute large transactions in these securities as it is with conventional nominalbonds, we expect this situation to improve as more market participants come to recognizethe advantages of such investments for inflation protection and portfoliodiversification.

We also think that, over time, arbitrageopportunities will develop between fixed-rate securities and inflation-indexed securitiesand among the inflation-indexed securities issued by the U.S. Government and otherissuers. A particularly interesting dimension of this arbitrage will be the internationalone, since it will shed light on the market's expectations as to the future course ofvarious bilateral real exchange rates.

Let me turn now to the longer termoutlook. The elimination of the Federal deficit over the next several years combined withnew issues of non-marketable Savings Bonds and State and Local Government SeriesSecurities (SLGS), will mean that new issues of marketable Treasury securities willlargely refund maturing marketable securities. Thus, as the Treasury continues to issuenew inflation-indexed securities, our need to issue fixed-rate securities will shrink andso will the risk premium that the Government pays to investors.

We have been interested to see articles inthe financial press expressing concern that the Treasury will not be issuing enough newfixed-rate debt to fill traders’ demand for liquid instruments for trading,arbitrage, and hedging purposes. Some have said that the Treasury will be substitutingless liquid debt instruments --inflation-indexed securities --for the more liquidfixed-rate marketable securities. This, I guess, is the flip side of the criticism of onlya couple years ago that Treasury borrowing was crowding out the market. How far we havecome!

We are sensitive to the benefits of, anddemands for, liquidity. And we intend to be very careful to ensure it. Treasury has $3trillion of marketable debt that is held by private investors, about one-third of whichmatures within one year and over half of which matures within two years. We will haveissued more than $2.1 trillion of new marketable securities --including roll-overs ofshort-term

bills --in FY 1997. New issues offixed-rate marketable securities, carefully managed, will continue to be large enough toensure market liquidity.

In conclusion, we are happy with theinflation-indexed program so far. And we are committed to expanding it going forward.Nevertheless, building infrastructure takes time and financial infrastructure is noexception. We still have important work to do to educate investors about the differencebetween real and nominal yields. As the nation's largest institutional investor and ourpartner in the financing of government, you can play a critical role in this process. Ilook forward to working closely with you as the program develops.