October 28, 1998 

DearMr. Secretary 

Since the Committee’s last meeting on August 5, 1998, the domestic economy has continued to 

perform reasonably well although there have been some signs that a moderation in the pace of 

activity lies ahead. The data available at this point suggest that 43 GDP expanded at about 

2.5%, versus the 3.7% average growth rate seen in the first half of the year. While consumer 

spending appears to be holding up well, business capital spending and residential construction 

activity show signs of moderation relative to the very robust growth seen earlier in the year. 

Finally, a widening in the trade gap continues to be a significant drag on overall growth. 

On the inflation front, the news remains generally favorable. There has been little sign of any 

acceleration in prices of core goods and services. Indeed quotes for energy items and other 

industrial commodities remain quite low by hstorical standards and prices of non-fuel imported 

goods continue to post significant declines. Meanwhile, available evidence suggests that labor 

markets remain tight and wage pressures continue to build. However, this process appears to be 

evolving very slowly. 

The immediate risk to sustained growth in the US economy arises from the effects of increasing 

softness in foreign economies and the sharp deterioration of financial conditions here at home. 

To limit these risks, and in view of the benign inflation environment, the Federal Reserve 

recently modified its restrictive policy stance by lowering its federal funds rate target from 

5.50% to 5.00% in two stages. The first move occurred at a regularly scheduled FOMC meeting 

on September 29. However, the financial markets remained very unsettled following this action 

and the Fed announced a further cut in the funds rate target and the discount rate on the afternoon 

of October 15. While the initial move by the Fed was widely anticipated, the timing of the latter 

action came as a surprise and lead to a strong market reaction. 

Yields on Treasury issues are 60 to 135 basis points lower than at the time of the Committee’s 

last meeting. The decline in yields began shortly after the refunding auctions and picked up pace 

toward the end of August, amid a heightened sense of global instability and a sharp drop in the 

US stock market. Yields on longer maturity Treasuries have backed up some over the past few 

weeks, and the spread between 2-year Treasury notes and 30-year bonds has widened from 

about 25 basis points in early August to about 1OObasis points at present. The fixed income 

markets have also experienced a significant widening in credit spreads and erosion in liquidity. 

The yield differential between Moody’s Aaa Industrial index and the 30-year Treasury has 

moved from about 60 basis points during the first half of the 1998 to about 120 basis points, 

currently. The spread widening experienced by lesser credits has been even more pronounced. 

In the capital markets, issuance of corporate debt came to a grinding halt in early October, as 

investors sought to avoid credit risk at all costs. Because nearly half of all credit intermediation 

in the US economy involves the capital markets, this development posed a potential risk for the 

pace of economic growth and appeared to play a role in the Federal Reserve’s decision to lower 

the fed funds rate on October 15. The early signs suggest that the Fed’s action was somewhat 

successful in restoring investor confidence and corporate issuance has picked up in recent days. 
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Still market conditions remain fragile and the US Treasury market remains priced for a 

significant amount of fbrther easing from the Fed. 

Within this context, to refbnd approximately $27.0 billion of privately held notes and bonds 

maturing on November 15, 1998, and to raise $12.0 billion of new cash, the Committee 

recommends by a 14-5 majority that the Treasury auction $39.0 billion of the following 

securities: 

0 

0 

0 

$1 7.0 billion 5-year notes due November 15,2003 

$12.0 billion 10-year notes due November 15,2008 

$10.0 billion of a 30-year bond 

The minority of 5 members expressed a preference for a refbnding that included $16 billion 5- 

year notes, $12 billion 10-year notes, and a larger bond offering of $1 1 billion. 

There was considerable discussion about the potential benefits and impact of the Treasury 

reopening existing issues for this refbnding offering. The discussion centered around the tradeoff between the presumably significant price benefit to the Treasury of offering new issues, 

against the potential long-run benefit of increasing market liquidity by adding to existing issues. 

This was viewed by some as particularly relevant in the context of the dislocations and relative 

illiquidity in current market conditions, and the extreme scarcity of these issues evident in 

financing markets. Other factors discussed by the Committee were the large maturity already 

present in the existing 5-year sector, the fact that the existing 10-year security had already been 

reopened, and the existing 30-year had not previously been reopened. In considering these 

factors, the Committee voted by a 13-6 majority for a new 5-year security, and by a 15-4 

majority for a new 10-year note offering. The Committee was evenly divided on the merits of 

reopening the existing 30-year bond. 

The Committee recommends that for the remainder of the quarter, the Treasury meet its 

borrowing requirement in the following manner: 

0 

0 

0 

0 

Two 2-year notes of $16.0 billion each, 

Two 1-year bills of $12 billion each, 

Weekly issuance of $16.0 billion of 3- L. and 6-month bills through the remainder of the 

quarter, and 

Two cash management bills -- $25.0 billion of a bill to be issued November 3 to 

mature January 2 1, 1999, and $15 .O billion of a bill to be issued December 1 to 

mature within the quarter. 

For the first quarter of 1999, the Treasury estimates a market borrowing requirement of $1520 

billion. To accomplish this requirement, the Committee recommends the provisional financing 

schedule in the attached table. 

At the Treasury’s request, the Committee discussed at some length the current conditions in the 

Treasury market, with a view toward whether the Treasury should respond to those conditions 

with modifications to its normal financing arrangements. Committee members noted the extent 
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to which price differences had developed between on-the-run and off-the-run Treasury securities, 

and the extreme and persistent scarcity of on-the-run securities in the rep0 market. These 

conditions were, at least in part, due to the deleveraging pressures being experienced in the 

global capital markets and the disruptions in primary and secondary market activity in the US 

credit and mortgage backed securities markets. In turn, thls was also diminishing somewhat the 

liquidity and efficiency of the US Treasury market, though in relative terms it remains the most 

liquid capital market in the world. 

Against this backdrop, the Committee debated the pros and cons of the Treasury responding to 

these market dislocations with actions to increase the available supply of on-the-run benchmark 

issues, while concurrently repurchasing in the secondary market less liquid, cheaper off-the-run 

issues. The Committee was evenly divided on the merits of such a course of action. 

Those in favor felt that the scale of dislocations was such that the Treasury could both lower its 

cost of fbnding and help improve market liquidity. Specifically, the Treasury could capture 

some portion of the wide disparity in yields between on-the-run and select off-the-run issues, and 

also help re-liquify the benchmark issues, thus diminishing somewhat the pressures in the 

financing market . Members recognized that, as a technical accounting matter, this would raise 

the level of interest expense in the current fiscal year to reflect expensing the premium paid to 

repurchase issues trading above par, while lowering fbture year interest expenses. As an 

economic matter, these members were confident that there would be real net savings to the 

Treasury, which could be clearly documented, and that the Treasury would have the flexibility to 

determine the extent and timing of any such initiative, to ensure that savings were in fact 

achieved. Members favoring this course of action also felt that the advantages of an 

opportunistic response to current dislocated market conditions would out weight any potential 

negatives, in terms of the impact on predictability and consistency of normal debt management 

operations. 

The other half of the Committee felt that such a course of action was not advisable at this time. 

For one, there was some doubt as to the certainty and scale of financial advantages to the 

Treasury, since the announcement effect of any such initiative would tend to cause a narrowing 

of those spreads. Moreover, the introduction of uncertainty, both as to the size and timing of any 

Treasury market operation, as well as the potential for fbture operations, would add a higher risk 

premium to the prices of on-the-run Treasury issues and diminish the long-term benefits of 

predictability. Finally, it was felt that in the current fragile market environment, the Treasury 

should avoid taking actions which might surprise the market and add fbrther volatility. 

The Committee then turned to the question of whether to extend the use of uniform-price 

auctions to 10- and 30-year maturities, as well as to Treasury bills. The Committee took note of 

the findings in the Treasury staff study released just prior to the meeting and to the summary 

analysis presented in the public portion of the Committee’s meetings at the Treasury. The 

Committee discussed the question of how well the uniform price auction techniques performed 

during 1994-the last period of sustained rising interest rates-and was advised by the staff that 

analysis of the 1994 subperiod did not suggest different results than for the longer period under 

review. 
I .‘ 

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The Committee agreed that the Treasury’s study showed clear benefits fiom the uniform price 

auction, in terms of broader participation in Treasury auctions. While the study also tends to 

support the conclusion that there was a modest price advantage to the Treasury from the use of 

the uniform price technique, the Committee noted that there are inherent limitations to any 

attempt to make precise quantification of those benefits. While the price benefits might be small 

and hard to quantify, there was certainly no evidence to suggest that the uniform price technique 

was disadvantageous to the Treasury, from a cost perspective. Finally, it was also noted that 

there was an additional benefit from uniform price auctions in terms of reduced post auction 

market volatility. Taken together, these benefits, along with the desire to see consistent auction 

techniques used in all Treasury offerings, lead the Committee to recommend, by a vote of 16-0 

(with three abstaining), that the Treasury adopt a uniform price auction technique for all hare 

offerings of Treasury securities. 

Finally, and at the Treasury’s request, the Committee discussed potential recommendations to 

improve the inflation-indexed securities market, now that the Treasury has announced a regular 

quarterly auction schedule. Committee members noted that the product continues to be impacted 

by a low level of secondary market activity and liquidity, which current market conditions have 

hrther exacerbated. In addition, there appears to be a need to continue with efforts to educate 

both the retail market and the pension consultants on the attractive features of the product. This 

includes both low cost protection against inflation and downside protection against deflation risk; 

as well as portfolio diversification features in a world where many other asset classes have 

become more correlated in times of market crisis. There was also a suggestion that, as the 

market came to better appreciate both the deflation as well as inflation protection features of the 

instruments, demand might improve somewhat and a preference develop for more new issues 

rather than periodic re-openings of outstanding securities. 

Even in this context, however, it was felt that the Treasury should re-evaluate the size of current 

offerings, with a view to rebalancing the program in line with the reduced amount of annual 

issuance of nominal coupon securities. At current sizes, the relative size of the program has 

increased and it represents a disproportionate share of new money raised in the coupon markets. 

An adjustment in issue sizes to about $6 billion per offering was viewed by most members as an 

appropriate modification, in line with the Treasury’s reduced refinancing needs, while still 

maintaining a long-term commitment to the product. 

+. Respecthlly submitted, 

Stephen G. Thieke