Working Paper #5 September 30, 2014

GOVERNMENT DEBT MANAGEMENT AT 

THE ZERO LOWER BOUND 

Robin Greenwood, George Gund Professor of Finance and Banking, Harvard Business School

Samuel G. Hanson, Assistant Professor, Finance Unit, Harvard Business School

Joshua S. Rudolph, Master in Public Policy, Harvard Kennedy School of Government

Lawrence H. Summers, Charles W. Eliot University Professor, Harvard University

ABSTRACT

This paper re-examines government debt management policy in light of the U.S.

experience with extraordinary fiscal and monetary policies since 2008. We first document 

that the Treasury’s decision to lengthen the average maturity of the debt has partially offset 

the Federal Reserve’s attempts to reduce the supply of long-term bonds held by private 

investors through its policy of quantitative easing. We then examine the appropriate debt 

management policy for the consolidated government. We argue that traditional 

considerations favoring longer-term debt may be overstated, and suggest that there are 

several advantages to issuing greater quantities of short-term debt. Under current 

institutional arrangements, neither the Federal Reserve nor the Treasury is caused to view 

debt management policy on the basis of the overall national interest. We suggest revised 

institutional arrangements to promote greater cooperation between the Treasury and the 

Federal Reserve in setting debt management policy. This is particularly important when 

conventional monetary policy becomes constrained by the zero lower bound, leaving debt 

management as one of the few policy levers to support aggregate demand.

This paper was prepared for Brookings Institution and reflects only the views of its authors. David Biery 

provided outstanding research assistance. We thank Ben Bernanke, Stephen Cecchetti, Derek Kaufman, 

Donald Kohn, Matthew Rutherford, Louise Sheiner, Jeremy Stein, Adi Sunderam, and David Wessel for 

many helpful comments.
Hutchins Center Working Paper #5

INTRODUCTION

At least since the 1980s, the domains of U.S. monetary policy, fiscal and debt management 

policy, and the prudential regulation of financial intermediaries have been separate and distinct. 

Fiscal authorities chose the level of the budget deficit and decided in what maturity and form 

federal debt would be issued. Monetary authorities determined the level of short-term interest 

rates with a view toward economic stabilization. And supervisory authorities regulated the 

capital and liquidity of banks and other financial intermediaries.

With the onset of the financial crisis in 2007 and 2008 and the subsequent easing of monetary 

policy, the clean lines between these domains have blurred. With short-term interest rates at the 

zero lower bound, conventional monetary policies have lost their impact. As a result, the Federal 

Reserve has resorted to quantitative easing (QE) policies to support aggregate demand. Because 

QE works by shortening the maturity structure of debt instruments that private investors have to 

hold, the Fed has effectively entered the domain of debt management policy. 1 And with the 

decision to pay interest on central bank reserves, the nearly $3 trillion of reserves on bank 

balance sheets have become the functional equivalent of Treasury bills not reflected in Treasury 

debt statistics. At the same time, the Treasury has been extending the average maturity of the 

debt to mitigate fiscal risks associated with the government’s growing debt burden. The 

Treasury’s actions have operated as a kind of reverse quantitative easing, replacing money-like 

short-term debt with longer-term debt.

This blurring of functions—and the observation that Federal Reserve and Treasury policies with 

regard to U.S. government debt have been pushing in opposite directions—suggests the need to 

reconsider the principles underlying government debt management policy. Building on recent 

work by Greenwood, Hanson, and Stein (2014), hereafter referred to as GHS, Rudolph (2014), 

and Summers’s efforts as a policymaker, this paper undertakes such a reconsideration. We 

address desirable policy on a consolidated government basis as well as the appropriate 

institutional arrangements needed to support it. We conclude that substantial changes in current 

practice are appropriate. We present our argument in 5 sections.

Section I documents the extent to which monetary and fiscal policies have been pushing in 

opposite directions in recent years. We show that, despite successive rounds of QE, the stock of 

government debt with a maturity over 5 years that is held by the public (excluding the Fed’s 

holdings) has risen from 8 percent of GDP at the end of 2007 to 15 percent at the middle of 

2014. Said differently, the volume of 10-year duration equivalent debt has doubled from 13

1 Discussing the Fed’s large-scale asset purchases, Yellen (2011) states that, “central bank purchases of longer-term 

securities work through a portfolio balance channel to depress term premiums and longer-term interest rates.”. 

Similarly, Bernanke (2012) has argued that “changes in the supplies of various assets available to private investors 

may affect the prices and yields of those assets. ... Declining yields and rising asset prices ease overall financial 

conditions and stimulate economic activity.” 

 
Hutchins Center Working Paper #5

percent of GDP to 26 percent of GDP over the same interval. Pressure to absorb long-term 

government debt has actually increased rather than decreased over the last six years!

We find that between two-thirds and three-quarters of the increased supply of longer-term 

Treasuries is explained by the dramatic growth in outstanding debt due to the large deficits 

associated with the Great Recession. The remaining one-quarter to one-third is due to the 

Treasury’s active policy of extending the average maturity of the debt.

In discussions of its QE policies, the Federal Reserve has focused purely on the effects that its 

bond purchases were expected to have on long-term interest rates and, by extension, the 

economy more broadly. However, in doing so, it completely ignored any possible impact on 

government fiscal risk, even though the Federal Reserve’s profits and losses are remitted to the 

Treasury. Conversely, Treasury’s debt management announcements and the advice of the 

Treasury Borrowing Advisory Committee (TBAC) have focused on the assumed benefits of 

extending the average debt maturity from a fiscal risk perspective, and largely ignored the impact 

of policy changes on long-term yields. To the extent that the Federal Reserve and Treasury ever 

publicly mention the other institution’s mandate, it is usually in the context of avoiding the 

perception that one institution might be helping the other achieve an objective. Specifically, the 

Fed does not want to be seen as monetizing deficits, while the Treasury has been reluctant to 

acknowledge the Fed as anything more than a large investor.

Section II places the current tension between Federal Reserve-led debt management and 

Treasury-led debt management in historical perspective. Before 2008, changes in Federal 

Reserve holdings of long-term bonds had only a tiny impact on the amount of long-term 

Treasury debt held by the public (i.e., Fed policy had little direct impact on the consolidated debt 

management strategy of the U.S. government). However, we describe a few historical examples 

in which the Federal Reserve and the Treasury agreed to coordinate policy for the purpose of 

achieving a common set of objectives with regard to debt management. Thus, history suggests 

that greater cooperation on debt management is certainly possible.

Section III considers the appropriate debt management policy on a consolidated government 

basis. Drawing on the work of GHS, we argue that optimal debt management policy balances a 

number of considerations. First, debt managers attempt to achieve a low cost of financing for 

taxpayers over time. For instance, the public benefits when debt is issued in forms that investors 

are eager to hold and, therefore, carries a lower equilibrium yield. As a number of authors have 

suggested, short-term Treasury bills have many of the same valuable properties as traditional 

money and therefore command a liquidity premium. As a result, short-term debt may be a 

‘cheaper’ form of financing than long-term debt. Second, it is desirable for the government to 

reduce the risks associated with government financing. Issuing longer-term debt may help 

insulate future taxes and spending from fluctuations in interest rates, while also guarding against 

the possibility, albeit remote, of a self-fulfilling debt rollover crisis. Third, to the extent that 

changes in the maturity structure of the debt influence long-term interest rates and other asset 

September 30, 2014 3
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prices, reductions in the average debt maturity are likely to have an expansionary impact on the 

economy—a consideration that looms large when monetary policy becomes constrained by the 

zero lower bound. Fourth, changes in the supply of short-term, money-like government debt may 

impact the amount of “liquidity transformation” pursued by private financial firms which, in 

turn, has potential ramifications for financial stability.

Our evaluation of these issues suggests that, on average, the case for shorter-term debt is stronger 

and the case for maturity extension is weaker than generally supposed. We develop arguments 

that: (1) issuing more shorter-term debt the government can generate substantial savings over 

time; (2) shortening the average maturity would only modestly increase fluctuations in the fiscal 

deficit and the gains from reducing the volatility of these fluctuations are arguably small; (3) at 

the zero lower bound, any reduction in term premia due to a shorter average debt maturity may 

have an important stimulative impact on aggregate demand; and (4) an increased supply of shortterm government debt is likely to enhance financial stability by counteracting the financial 

system’s tendency toward excessive liquidity transformation. To illustrate point (2), we perform 

a counterfactual exercise in which we compute the path of the debt and deficits since 1952 had 

the Treasury financed its spending entirely using 3-month T-bills.

We further show how the forces listed above vary over time. This implies that the optimal 

maturity structure of the debt is not constant. For instance, we note that many of the forces that 

typically favor a shorter term maturity structure are currently weak.

Section IV briefly applies the framework to issues in debt management policy beyond maturity 

structure, including the appropriate mix between inflation-indexed and nominal debt.

Section V proposes an alternative institutional framework which we believe should promote 

greater cooperation between the Treasury and the Federal Reserve in setting debt management 

policy. Adopting our tradeoff perspective, we describe the settings in which, under current 

institutional arrangements, the Treasury may come into conflict with the Federal Reserve. While 

the potential for conflict is greatest when interest rates are at the zero lower bound, we suggest 

that a lack of coordination leads to suboptimal policy during ordinary times as well, although the 

costs are not as great because the Fed can offset debt management decisions using the short-term 

interest rate. During normal times, conflict can arise because there are only two policy 

instruments—the short rate and debt management—with at least four policy objectives. These 

conflicts are exacerbated when interest rates become constrained by the zero lower bound. We 

suggest how improved policy coordination could reduce these conflicts. At the zero lower bound,

a fully coordinated policy—such as the Treasury and the Fed already pursue with respect to 

currency intervention—should be the norm.

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I. FED VERSUS TREASURY: 2008–2014

Starting in 2008, U.S. monetary policy and debt management dramatically changed course in 

response to the unfolding financial and economic crisis, pulling the government balance sheet in 

opposite directions.

Table 1 shows a stylized depiction of the major financial assets and liabilities of the U.S.

government in December 2007 and July 2014. The size of the Federal Reserve’s balance sheet 

has grown fivefold over this period due to its purchases of $1.8 trillion of long-term Treasuries 

and $1.8 trillion of mortgage-backed securities (MBS) and Agency securities, financed by an 

increase in interest-bearing reserves. 2 , 3 The duration of the Federal Reserve’s portfolio of 

Treasury securities increased from 3.3 years to 7.8 years.

4 At the same time, Treasury debt 

outstanding rose from 31 percent of GDP in 2007 to 70 percent of GDP in 2014. The duration of 

the outstanding Treasury debt increased from 3.9 years to 4.6 years. On a consolidated basis,

however, the duration of the U.S. government’s liabilities has moved very little, from 4.0 years 

to 2.9 years, as Table 1 shows.

This section isolates the policy-driven component of these changes, and assesses the net impact 

of these policies by converting them into common and economically meaningful units of interest 

rate risk. We start with the Federal Reserve’s balance sheet, summarized in Panel A of Table 2 at 

year-end dates beginning in December 2007. The vast majority of the securities held by the 

Federal Reserve System are held in the System Open Market Account (SOMA). In December 

2007, securities held in the SOMA had a face value of $750 billion. These securities were 

comprised of mostly Treasury bills, notes and bonds, with an average duration of 3.3 years, 

similar to the duration of outstanding Treasury debt. After falling in 2008, by December 2009 the 

face value of all securities in the SOMA had reached $1,839 billion, including $771 billion of 

Treasury securities, $160 billion of debt issued by Fannie Mae and Freddie Mac (the GSEs), and 

$908 billion of MBS guaranteed by the GSEs and Government National Mortgage Association 

(GNMA). By July 2014, the securities held by the SOMA had doubled again, reaching $4,121 

billion (58 percent in U.S. Treasuries, 41 percent in MBS, 1 percent GSE debt). Thus, the total 

increase from 2007 was $3,371 billion, or 19.4 percent of 2014 GDP.

2 The initial surge in the Fed’s balance sheet occurred after Lehman Brothers’ failure in September 2008 and was

due to lending to private intermediaries and firms under various liquidity facilities. Since early 2009, Fed balance 

sheet growth has been due to large-scale asset purchases (LSAPs), often referred to as quantitative easing (QE). 3 Historically, the Fed did not pay interest on reserves, and instead controlled short-term nominal interest rates by 

varying the supply of reserves to target a desired level for the rate on overnight loans between banks (the Federal 

funds rate). However, central banks in many other countries control short-term rates by paying interest on reserves. 

The Fed obtained the authority to pay interest on reserves under the Emergency Economic Stabilization Act of 2008. 4 Duration is the weighted average time to receipt of the cash flows on a bond. Duration captures the sensitivity of a 

bond’s price to its yield and is an indicator of how much interest rate risk is being borne by a bondholder.

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Table 1

Consolidated U.S. Government Balance Sheet: 2007 versus 2014

Table 1 shows a stylized depiction of the major financial assets and liabilities of the U.S. Treasury and Federal 

Reserve in December 2007 and September 2014. FV denotes face value of the claim in trillions of U.S. dollars, and 

Dur denotes the Macaulay duration in years, as estimated by the authors based on the July 2014 yield curve. 

Consolidation nets out the Treasury debt that is held by the Federal Reserve. The table is based on the authors’ 

calculations using data from the Treasury’s Monthly Statement of the Public Debt, the Federal Reserve System’s 

H.4.1 Release (Factors Affecting Reserve Balances), and the Federal Reserve Bank of New York’s System Open 

Market Account Holdings release.

Assets Liabilities

December 2007 July 2014 December 2007 July 2014

FV

($tr)

Dur

(yrs)

FV

($tr)

Dur

(yrs)

FV

($tr)

Dur

(yrs)

FV

($tr)

Dur

(yrs)

Federal Reserve

Treasury Debt $0.7 3.3 $2.5 7.8 Currency $0.8 N/A $1.2 N/A

MBS + Agency 

Debt $0.0 N/A $1.8 5.6 Reserves $0.01 0.0 $2.7 0.0

Other $0.1 N/A $0.1 N/A Other $0.1 0.0 $0.4 0.0

Treasury

Taxing Power N/A N/A N/A N/A Treasury 

Debt $4.5 3.9 $12.2 4.6

Consolidated Balance Sheet

Treasury 

Debt $3.8 4.1 $9.6 3.8

Taxing Power N/A N/A N/A N/A Currency $0.8 N/A $1.2 N/A

MBS + Agency 

Debt $0.0 N/A $1.8 5.6 Reserves $0.01 0.0 $2.7 0.0

Other $0.1 N/A $0.1 N/A Other $0.1 0.0 $0.4 0.0

Total $0.1 N/A $1.9 N/A Total $4.6 4.0 $14.0 2.9

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Table 2

Quantitative Easing and Treasury Maturity Extension: 10-Year Duration Equivalents

Panel A describes the impact of QE programs on the Federal Reserve balance sheet, at year-end dates beginning in 

December 2007. SOMA refers to the System Open Market Account. Between 2003 and 2007, the SOMA was an 

average of 95% of currency in circulation. We define QE Impact to be SOMA minus 0.95×currency in circulation. 

To convert into 10-year duration equivalents, we multiply face values by the ratio of portfolio duration (denoted by 

Dur) to the duration of a 10-year bond (8.9 years). Duration is computed based on the July 2014 yield curve. Panel 

B describes the impact of U.S. Treasury’s expansion and maturity extension of the public debt. We convert 

Treasuries outstanding into 10-year equivalents. We further break down the cumulative change in 10-year duration 

equivalents between December 2007 and July 2014 (estimated) into two components: the expansion of the debt and 

the maturity extension according to:

10 10 1

Debt Expansion Maturity Extension

t t 1 yr yr tt t t

t t

Debt Dur Debt Dur Dur Debt

Dur Dur − − −

     ⋅ ∆ = ⋅ ∆ +∆            

Duration of Federal Reserve Holdings and outstanding Treasury debt are computed by the authors as described in 

the text. The table is based on the authors’ calculations using data from the Federal Reserve System’s H.4.1 release 

(Factors Affecting Reserve Balances) and the Treasury’s Monthly Statement of Public Debt. GDP is from the 

Bureau of Economic Analysis.

Panel A: Impact of Quantitative Easing Panel B: Impact of Expansion of Debt and 

Treasury Maturity Extension

Fed Holdings 10-Year Equivalents Debt 

Outstanding 10-Year Equivalents

SOMA

($bn)

Currency 

x 0.95

QE 

($bn)

Dur

(yrs)

SOMA

($bn)

QE

($bn)

QE

% 

GDP

Debt

($bn)

Dur

(yrs)

Total

($bn)

Cum Δ

%GDP

Debt 

expand 

% GDP

Mat 

Extend 

% GDP

12/2007 750 784 0 3.3 279 0 0.0% 4,537 3.9 2,005 0.0% 0.0% 0.0%

12/2008 490 844 0 5.4 299 0 0.0% 5,798 3.5 2,287 1.9% 3.8% -1.9%

12/2009 1,839 883 956 5.4 1,119 744 5.4% 7,272 3.9 3,189 8.1% 8.3% -0.2%

12/2010 2,150 934 1,215 5.3 1,288 941 6.2% 8,863 4.1 4,101 13.8% 12.6% 1.2%

12/2011 2,604 1,020 1,584 5.6 1,655 1,276 8.1% 9,937 4.3 4,817 17.7% 15.1% 2.7%

12/2012 2,649 1,105 1,544 7.2 2,144 1,733 10.6% 11,053 4.5 5,535 21.5% 17.6% 4.0%

12/2013 3,743 1,178 2,564 7.0 2,938 2,500 14.6% 11,869 4.5 6,066 23.8% 19.0% 4.8%

7/2014 4,121 1,220 2,901 6.8 3,172 2,718 15.6% 12,163 4.6 6,339 24.9% 19.4% 5.5%

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To estimate the impact of QE—as opposed to the normal growth in the size of the Fed’s balance 

sheet due to the growth in the demand for currency in circulation—we adjust the growth in the 

SOMA for growth during ordinary times. A simple way to do this is based on the observation 

that from 2003 to 2007 the SOMA averaged 95 percent of currency in circulation. Thus, we 

estimate the abnormal growth in the Fed’s balance sheet due to QE by subtracting 0.95 times 

currency in circulation. Column (3) shows that this adjustment implies a cumulative abnormal

growth in the Fed’s balance sheet of $2.9 trillion between December 2007 and July 2014.

If one’s objective is simply to assess the scale of the Federal Reserve’s balance sheet, one could

simply track the face value of its security holdings, as we have just done. However, the goal of 

QE was to reduce the amount of interest rate risk borne by private investors, thereby lowering 

long-term interest rates through a portfolio balance channel. Thus, the analysis is more 

informative if holdings are converted into common units. We do so by adjusting Federal Reserve 

holdings by their Macaulay duration, which captures the weighted average maturity of the debt.5

Specifically, we convert the Federal Reserve holdings into “10-year duration equivalents” by 

multiplying the face value of the portfolio by its weighted average duration, and dividing the 

result by the duration of a 10-year Treasury note.

10

10 . yrEquivalent t t

t yr

t

Debt Dur Debt

Dur

−

−

⋅ = (1)

This calculation recognizes that, from the perspective of private investors, the amount of interest 

rate risk they are asked to bear would be the same if there were $1 trillion 20-year zero-coupon 

bonds as if there were $2 trillion 10-year zero-coupon bonds.6 Likewise, this calculation treats 

the purchase of $1 billion 10-year zero-coupon Treasury bonds as equivalent to $1 billion MBS

with a duration of 10 years. Put differently, this calculation implicitly assumes that the relevant 

policy instrument in the case of QE is the total amount of duration removed from the bond 

market.7 Our conclusions here are not sensitive to methodology; we obtain similar results if we 

instead convert SOMA holdings and Treasury issuance into common units by simply rescaling 

by maturity. 

5 Vayanos and Vila (2009) and Greenwood and Vayanos (2014) show that bond supply shocks may impact term 

premia if they change the amount of interest rate risk that must be borne by fixed income investors. 6 This is only strictly true if the yield curve shifts in a parallel fashion.

7 This is a clear simplification because it implies that it does not matter in which market the duration is purchased. In 

perfectly integrated fixed-income markets a $1 purchase of 5-year duration MBS has the same policy impact as a $1 

purchase of 5-year duration Treasuries. Krishnamurthy and Vissing-Jorgensen (2011, 2012) find strong evidence 

that the market for Treasury securities is partially segmented from agencies and MBS. At the same time, Hanson 

(2014) finds evidence that duration supply shocks in the MBS market are transmitted nearly one-for-one to the 

broader fixed income market. Greenwood, Hanson, and Liao (2014) formally explore bond pricing dynamics in a 

setting in which a pair of markets is partially segmented in the short run, but is more integrated in the long run.

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Hutchins Center Working Paper #5

To compute the duration of all securities in the SOMA, we combine our estimate of the average 

duration of the Fed’s Treasury holdings with an estimate of the duration of its MBS and agency 

holdings. To isolate changes in duration due to changes in the Fed’s holdings—as opposed to 

changes in the term structure of interest rates—we compute duration based on a constant yield 

curve on July 31, 2014. Table 2 shows that the combined duration impact of the Fed’s QE 

policies, which is $2,901 billion in face value terms, was $2,718 billion in 10-year equivalents, 

or 15.6 percent of GDP through July 2014.

In Panel B of Table 2, we describe the growth in outstanding Treasury debt since 2007 and the 

Treasury’s decision to extend the maturity of the debt. We focus on marketable Treasury 

securities held by the public and the Federal Reserve. Data were obtained from the Monthly 

Statement of the Public Debt. As shown in the table, the weighted average duration of 

outstanding Treasury debt first fell from 3.9 years in December 2007 to 3.5 years in December 

2008, after which it rose to 4.6 years in July 2014. This rise in maturity occurred alongside a 

dramatic increase in outstanding Treasury debt, which grew from $4.5 trillion in December 2007 

to $12.2 trillion by July 2014.

To compare the increase in Treasury supply with the growth of the Federal Reserve’s balance 

sheet, we again convert these quantities into 10-year duration equivalents. The adjustment has a 

large impact because the average duration of outstanding Treasuries is considerably shorter than 

the duration of the Federal Reserve portfolio, which disproportionately contains long-term bonds 

as a result of QE. Expressed in 10-year duration equivalents, the debt grew from $2 trillion in 

December 2007 to $6.3 trillion in July 2014. Thus, the total increase from 2007 was $4,334 

billion in 10-year equivalents, or 25 percent of GDP.

The growth in the quantity of 10-year duration equivalents issued by the Treasury reflects two 

forces: the expansion of the debt and maturity extension. More formally, we can decompose the 

change in 10-year duration equivalents into two terms:

10 10 1

Debt Expansion Maturity Extension

t t 1 yr yr tt t t

t t

Debt Dur Debt Dur Dur Debt

Dur Dur − − −

     ⋅ ∆ = ⋅ ∆ +∆            

(2)

The first term reflects the growth of the debt, holding constant the duration of the debt at its 

initial value. The second term captures the effects of the rise in the average duration. Since debt 

management policy plays almost no role in driving the short-term growth of the debt stock 

(which is driven by fiscal policies outside the control of debt managers), the second term

captures the impact of active debt management policies. 

This decomposition is shown in the last two columns of Table 2. Roughly a quarter of the 

increase in 10-year equivalents was driven by the extension of maturity, with the remaining three 

quarters driven by the expansion of the debt. Comparing Panel A and Panel B of Table 2, we see 

that the Treasury’s active maturity extension program offset 35 percent of the duration supply 

September 30, 2014 9
Hutchins Center Working Paper #5

impact of QE, insofar as the proximate goal of QE was to reduce the amount of interest rate risk 

in private hands. More specifically, QE reduced the supply of 10-year duration equivalents by 

15.6 percentage points of GDP, but the maturity extension increased the net supply of 10-year 

equivalents by 5.5 percentage points of GDP. Because of our choice of a 2007 baseline, these 

numbers are a conservative estimate of how much the Treasury’s maturity extension offset QE; if 

we use December 2008 instead, 63 percent of QE was “canceled” by the Treasury’s maturity 

extension. Irrespective of which baseline we use, when measured in 10-year equivalents, the 

combined effect of maturity extension and the increased debt stock far outpace QE.

The calculations we have just described are shown graphically in Figure 1. Panel A shows the 

cumulative duration supply impact of the rising debt stock and the Treasury’s maturity extension. 

Below the x-axis, we show the offsetting duration supply impact of QE, which the figure further 

breaks into Treasuries, Agencies, and MBS. Units are in 10-year duration equivalents, scaled by 

GDP. Panel B shows the weighted average duration of Treasury debt, both taking account of and 

ignoring consolidation of the Federal Reserve and Treasury balance sheets.

Figure 2 provides a back-of-the-envelope estimate of the net impact on long-term yields by 

combining our duration supply estimates from Table 2 and Figure 1 with consensus estimates of 

the price impact of Fed asset purchases. Specifically, based on the meta-analysis in Williams 

(2014), we assume that a $600 billion large-scale asset purchase (corresponding to $397 billion 

10-year duration equivalents) lowers the 10-year term premium by 20 basis points (bps). This 

suggests that the cumulative impact of QE has lowered the term premium by 137 bps [=20 × 

(2,718 ÷ 397)]. At the same time, Treasury’s active maturity extension has raised the term 

premium by 48 bps [=20 × (962 ÷ 397)], for a net reduction of 88 bps. While these calculations 

are crude, they capture the stark difference between Fed and Treasury debt management policy.

8

8 Specifically, Figure 2 assumes that the entire impact of LSAPs works through reductions in term premia, which is 

a simplification (see below). Furthermore, it applies a constant price impact to these supply shocks. In practice, there 

are good reasons to think that the price impact of supply shifts may be diminishing and that there be diminishing 

stimulative benefits to reducing term premia, Stein (2012b). However, there is little evidence on these scores.

September 30, 2014 10

 
Hutchins Center Working Paper #5

Figure 1

Comparing Quantitative Easing and Treasury Maturity Extension, 2007–2014

Panel A presents the cumulative change in 10-year equivalents (scaled as a percentage of GDP) associated with 

the respective balance sheet policies undertaken by the Federal Reserve and the Treasury. Positive values 

increase the interest rate risk placed in public hands (Treasury policies), while negative values decrease it

(typically Fed QE, but also Treasury maturity shortening in 2008–2009). Panel B presents the weighted average 

duration (WAD) of Treasury debt, as well as the WAD of the consolidated government debt position. The 

difference between the two lines is that Treasuries held by the Fed are excluded from the consolidated duration, 

and short-term interest-bearing Fed liabilities (excess reserves and reverse repos) are added.

Panel A. 10-year Equivalents, QE vs. Treasury Maturity Extension

Panel B. Weighted Average Duration

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Figure 2

Estimating the Market Impact of QE and Treasury Extension

The figure estimates the impact QE and Treasury maturity extension had on the 10-year Treasury term 

premium. The calculations are based on our 10-year duration equivalents in Table 2, as well as the price-impact 

estimates in Williams (2014). Williams summarizes results from a large number of research papers that differ in 

methodology and data, finding a central tendency that a $600 billion Fed LSAP lowers the 10-year yield by 15 

to 25 basis points. In order to convert this $600 billion face value into 10-year equivalents, we assume a LSAP 

purchases with a duration of 5.86 years and a 10-year bond duration of 8.84 years. These numbers come from 

the announcement of QE2, which is the purchase program that established the tradition of scaling QE studies to 

an amount of $600 billion. The result is that $600 billion equates to $397 billion of 10-year equivalents. Using 

the midpoint of the Williams central tendency, we assume that $397 billion of 10-year equivalents impacts the 

term premium by 20 basis points.

This finding has both positive and normative implications. From a positive perspective, much 

has been made in recent years of the impact of QE not just on long-term yields (Gagnon, Raskin, 

Remach, and Sack 2011), but also on stock prices, exchange rates, and foreign asset prices.9 A 

common view is that Fed asset purchases have a mechanical downward effect on long-term 

interest rates through the so-called portfolio balance channel. To the extent that QE is thought to 

operate through such a direct channel, the argument has to confront the reality that the totality of 

policy has raised rather than reduced the quantity of long-term government debt held by private 

investors. It is not consistent to believe—as some seem to—that QE primarily works through a 

direct price pressure effect that reduces yields, but that the crowding out effects of large 

prospective deficits can be largely neglected. 

But if the direct supply effects of QE have been offset by the massive expansion in outstanding 

government debt and the Treasury’s decision to extend the debt maturity, then what explains the 

9 See, for instance, Neely (2012), Bauer and Neely (2014), Hooper, Slok, and Luzzetti (2013), Glick and Leduc 

(2013), Mamaysky (2014).

-160

-140

-120

-100

-80

-60

-40

-20

0

Impact of QE Impact of Treasury

Maturity Extension

Consolidated

Government Impact

Impact on 10-year Treasury Yield

-137 bp

+48 bp

-88 bp

Impact on 10-year Treasury Yield

-137 bp

+48 bp

-88 bp

September 30, 2014 12

 
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large market impact of QE announcements documented in so many studies, as well as the fact 

that estimates of term premia on long-term bonds have been steadily driven into negative 

territory and remain miniscule today, as shown in Figure 3? The most natural explanation is that 

the Fed’s announcements about its intended asset purchases also conveyed information about its 

future policies, including both the likely path of future short-term rates and the Fed’s willingness 

to undertake further asset purchases in response to evolving economic conditions.10 Furthermore, 

as Stein (2013a) argues, there are good reasons to think that the Fed’s announcements and its 

accommodative policies may have lowered the term premium on long-term bonds through a 

number of more indirect channels.11

Carrying this logic further, there are reasons to think that announcements of Fed asset purchases 

may have a greater impact on term premia than comparably sized Treasury supply 

announcements. Consistent with this, Rudolph (2014) provides event-study evidence suggesting

that Fed announcements have about twice the impact as Treasury announcements of a similar 

size. Rudolph’s analysis is reproduced in Figure 4. Specifically, the figure shows the daily 

change in the estimated 10-year term premium based on the Kim and Wright (2005) model in 

response to Treasury’s quarterly refunding announcement. The estimated term premium rose by 

25 bps cumulatively over the five quarterly refunding dates when the Treasury clarified it 

intention to extend the average maturity of the debt. As noted above, this is only half of the price 

impact (+48 bps) that one would have anticipated based on an extrapolation of LSAP price 

impacts.12

10 There is strong evidence that the Fed’s LSAP announcements moved the expectations component of long-term 

interest rates by essentially serving as an implicit form of forward guidance about the path of future short-term 

interest rates. See, e.g., Krishnamurthy and Vissing-Jorgenson (2011, 2013) and Bauer and Rudebusch (2014). 

However, we are skeptical of the view that Fed has used LSAPs in an attempt to credibly commit to keeping short 

rates lower for longer than it otherwise might because, say, the Fed is concerned with maintaining a certain level of 

remittances to Treasury. Indeed, the Fed has repeatedly emphasized that the future evolution of short-term rates will 

not be limited by the elevated size of its balance sheet and its large holdings of long-term bonds. Nonetheless, 

Gagnon, Raskin, Remache, Sack (2011) have used model-based estimates to argue that movements in term premia 

explain the vast majority of the announcement effect on 10-year yields. However, Bauer and Rudebusch (2014) are 

skeptical about the ability of such models to accurately disentangle term premia from expected short rates. 11 In particular, the Fed’s policies may have boosted investor demand for long-term bonds holding fixed the expected 

path of short-term rates. First, the expectation that the Fed would “do whatever it takes” using both conventional and 

unconventional measures may have lowered the perceived risk of investing in long-term bonds going forward. 

Second, a decline in interest rates may boost the demand for long-term bonds from investors who want to maintain 

the current yield on their portfolios (Hanson and Stein 2014). If such a demand “recruitment channel” is operative, it 

means that the Fed’s total impact on long-term yields may exceed the effect of any forward guidance on the 

expectations component and the direct effect of asset purchases on term premia (Stein 2013a). 12 An alternative interpretation is that Fed asset purchases and Treasury supply changes have the same price impact, 

but that it is easier for investors to predict the evolution of Treasury supply than Fed purchases. As a result, much of 

the supply “news” released on quarterly refundings may already be reflected in term premia. In contrast, investors 

may have been more surprised by the Fed’s LSAP announcements, leading to larger announcement effects.

September 30, 2014 13

 
Hutchins Center Working Paper #5

Figure 3

Estimated Term Premia on Long-Term Bonds

This figure shows estimates of the term premium on 10-year zero-coupon Treasuries based on the Kim and 

Wright model (Kim and Wright 2005). This model decomposed long-term yields into an “expectations 

component” that reflects the expected short-term interest rate over time plus a “term premium” that investors 

require for bearing the interest rate risk associated with long-term bonds. Major QE announcements are marked

by lines in Panel B.

Panel A: Term Premium on 10-Year Zero-Coupon Treasuries (1990 to 2014)

Panel B: Term Premium on 10-Year Zero-Coupon Treasuries (2008 to 2014)

-1.0

0.0

1.0

2.0

3.0

1990 1995 2000 2005 2010

%

September 30, 2014 14
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Figure 4

Event Study: Impact of Treasury Refunding Announcements on Term Premia

Panel A shows the weighted average maturity (WAM) of marketable Treasury debt over the past decade. Panel 

B adds up the daily and cumulative changes in the 10-year term premium on days when the Treasury’s quarterly 

refunding announcements were released. These documents are released at 8:30 a.m. on a Wednesday once every 

three months, which is how Treasury debt management policies are publicly announced. This approach of 

adding up daily changes in the term premium on announcement dates follows the methodology of QE event 

studies such as Gagnon, Raskin, Remache, and Sack (2011). The WAM data and refunding dates are sourced 

from the Treasury. The term premium data is from Kim and Wright (2005). Shaded in both panels are the five 

quarters when the Treasury was telegraphing its intent to extend the average maturity of the debt in its refunding 

announcements.

Panel A: Weighted Average Maturity of Marketable Treasury Securities

Panel B: Impact of Treasury Refunding Announcements on Term Premia

4.0

4.5

5.0

5.5

6.0

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Weighted Average Maturity (WAM) of 

Marketable Treasury Securities 

(years)

1

3

0 -1

0

0

-3

3 2 3

-2 -2 -3

1

0

5

8

-3

-1

-5

4

6 6

5 4

-3

4

-1

4

-2 0

1

3

-2

4

-1

-4 -3 -2 -4

4

-3

-1

-10

0

10

20

30

40

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Daily change

Cumulative change since

2004

Changes in the 10-year term 

premium on days when the Treasury 

quarterly refunding statement is 

released (bp)

+25 

bp

September 30, 2014 15
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Nonetheless, from a normative perspective it seems very odd that the Federal Reserve is taking 

actions that have the effect of substantially reducing the duration of the debt held by the public at 

a time when the Treasury is arguing that it is in taxpayers’ interest to extend the duration of the 

debt at a rapid pace. Moreover, the Federal Reserve has done so without formally acknowledging 

any of the considerations invoked by the Treasury. Similarly, the Treasury is taking steps that in 

the judgment of the Fed are contractionary, while committing itself in general to expansion of 

demand as a principal policy without ever addressing the concern about contractionary policy. 

Below we consider the merits of lengthening versus shortening the maturity of the public debt 

and address the question of the process by which a government committed to both democratic 

control over economic policy and an independent central bank should address this issue.

II. PRECEDENTS FOR FED–TREASURY COOPERATION

Before the 2008–2009 financial crisis, it was thought by academics and policymakers that the 

Federal Reserve’s dual objectives of low inflation and full employment were not in conflict with 

those of debt managers at the U.S. Treasury, who sought to minimize the cost of managing the 

federal debt while limiting fiscal risk. This understanding reflected the reality that the Treasury 

and the Federal Reserve each could independently pursue their respective policy objectives 

without much formal coordination. 

This has not always been the case. Prior to the late 1970s, coordination between the Treasury and 

the Federal Reserve was commonplace, and can be seen in both official communications and the 

correlation between the balance sheet positions of the two agencies. 

A. Historical precedents

Figure 5 provides an historical perspective on the link between the Federal Reserve holdings of 

Treasury securities, expressed as a percentage of GDP, and the size of the overall public debt. 

Over our 1936–2013 sample13, the correlation between these two series is 66 percent, which 

mostly reflects central bank balance sheet growth during World War II and the Great Recession. 

Outside of these two large events, in the 1952–2007 period, the correlation between the size of 

the Fed’s balance sheet and the ratio of debt-to-GDP is near zero.

13 There is limited data on the maturity structure of Federal Reserve securities holdings prior to 1936.

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Figure 5

Fed and Treasury Balance Sheets, 1936-2013

Outstanding balances of Federal Reserve (asset) and Treasury (liability) balance sheets are broken down into 

three buckets of remaining maturity: less than 1 year, 1–5 years, and greater than 5 years. Panel A shows this 

data expressed as a percentage of total Treasury assets (Fed) or Treasury liabilities (Treasury). In Panel B, 

outstanding amounts are shown as percentage of GDP. In Panel C, we show the long-term debt share, computed 

as the fraction of debt that is of 5-year maturity or greater. The Consolidated time-series nets out Federal 

Reserve holdings from Treasury liabilities. Data were compiled from various issues of the Monthly Statement 

of the Public Debt, Treasury Bulletin, Banking and Monetary Statistics, and Federal Reserve Bulletin.

Panel A. Breakdown by Maturity

Panel B. Notional Values, as a % of GDP

Panel C. Long-term Debt Share, Fed vs. Treasury

-100%

-50%

0%

50%

100%

1936 1943 1950 1957 1964 1971 1978 1985 1992 1999 2006 2013

% of Portfolio

Treasury

1-5y

Fed

>5y

> 5y

1-5y

< 1y

-25%

0%

25%

50%

75%

100%

1936 1943 1950 1957 1964 1971 1978 1985 1992 1999 2006 2013

% of GDP

Treasury

< 1y 1-5y

Fed

> 5y

> 5y

1-5y

< 1y

0%

20%

40%

60%

80%

100%

1930 1940 1950 1960 1970 1980 1990 2000 2010 2020

Long-term Share/Total

Long-term share Fed Long-term share Treasury Long-term Share (Consolidated)

<1y

September 30, 2014 17
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Panels B and C show that there is little correlation between the maturity structure of federal debt 

and the maturity structure of Treasury holdings on the Fed’s balance sheet. Although the figure 

shows periods when a lengthening maturity of outstanding Treasury debt was also associated 

with a maturity extension within the Fed’s portfolio (e.g., 1995–2007), the overall correlation is 

zero. The most discernible variation in the time-series, apart from the post-crisis era (i.e. 2008–

2013), is the 1940–1950 sub-period, when the Fed played an important role in facilitating the 

rapid growth in national borrowing during World War II.

From the long history of debt management, there are a few interesting episodes that suggest debt 

management can be better coordinated when the circumstances warrant. Consider first the 

cooperation between the Fed and Treasury on debt management during World War II. A few 

months after the U.S. entered World War II, and in the midst of a rapid increase in government 

spending, the Fed and the Treasury agreed to fix the entire yield curve of Treasury securities. 

Three-month bill yields were limited to 0.375% and bond yields were held at 2.5%. The Fed 

stood ready to buy or sell any amount of treasury securities necessary to maintain this positivelysloped yield curve.

Because long-term rates were fixed, bonds experienced almost no price volatility in the 

secondary market, a condition that made them more attractive to investors. But while such an 

increase in the appeal of long bonds might otherwise flatten the yield curve, the Fed had 

committed itself to enforce a positive slope. The result was that during World War II, private 

investors bought almost all of the notes and bonds issued by the Treasury, which left the Fed to 

buy almost all of the bills. This can be seen in Figure 5, where the share of long-term Treasury 

securities on the Fed’s balance sheet plummets. In short, the Federal Reserve and Treasury 

effectively agreed during World War II that financing the war was the main objective of debt 

management policy, and they coordinated with each other to reach this outcome. While the 

nature of the cooperation (the Federal Reserve was acting to support fiscal expansion) does not 

carry over to the current debate, the fact that they could cooperate closely on debt management 

does have implications for current policy.

Following the end of World War II, the Federal Reserve sought to assert independence by 

pushing for greater fluctuations in short-term interest rates. However, as the Treasury faced a 

large and growing debt burden, it maintained its pressure on the Fed until 1947 (Chandler 1966, 

Humpage 2014). In this way, monetary policy objectives were secondary to those of debt 

management. In 1947, the Treasury and Fed jointly agreed to a series of increases in the interest 

rate on short-term bills, which reached 1 percent in early 1948. This led some individuals and 

banks to sell their holdings of longer maturity bonds. In response, the Fed began purchasing 

these longer-term securities while simultaneously selling an approximately equal value of shortterm Treasury bills (Humpage 2014).

Tension between the Treasury and Fed reached a boiling point in January 1951, when the 

Treasury Secretary publicly announced that maintaining a 2.5 percent yield on Treasury bonds 

September 30, 2014 18
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was an “integral part of the financial structure of the country.” The Federal Reserve, in a memo 

to President Truuman, stated that it did not agree with the directive. Following intervention by 

the President, the Secretary of the Treasury and the Chairman of the Federal Reserve released a 

joint statement in March 1951 that declared “The Treasury and the Federal Reserve System have 

reached full accord with respect to debt-management and monetary policies to be pursued in 

furthering their common purpose to assure the successful financing of the Government’s 

requirements and, at the same time, to minimize monetization of the public debt” (Hetzel and 

Leach 2001). This agreement restored greater independence to the Fed and became known as the 

1951 Treasury-Federal Reserve Accord.

A second instance of cooperation—in fact a series of repeated instances—occurred through the 

“even keeling” policy the Fed abided by in the years after the 1951 Accord. The Fed agreed to 

not alter monetary policy during the 3-week periods when the Treasury was building up an order 

book for new debt issues in the primary market. Under the even keeling policy, the Fed would 

hold rates steady during Treasury offerings, thus avoiding disruptive changes that might 

endanger the success of the offering process. Wanting to limit the amount of time when 

monetary policy was unable to change, the Treasury began concentrating its issuance into four 

annual mid-quarter refundings (Garbade 2007). But overall, the even keeling process was meant 

to ensure that central bank objectives did not interfere with debt management.

The third and most prominent example of Fed and Treasury cooperation in the domain of debt 

management comes from the Operation Twist program of 1961. At the time, the Fed wanted to 

adopt a more accommodative policy but was reluctant to further reduce short-term interest rates

because of concerns that this would impair the nation’s balance of payments and result in gold 

outflows under the Bretton Woods system. In response, the Fed and Treasury tried to lower longterm interest rates by reducing the term premium on long-term bonds while holding short-term 

interest rates constant. Specifically, the Fed agreed to buy longer-term securities while the 

Treasury would sell predominantly short-term securities. Studies conducted shortly thereafter 

used quarterly interest rate data and found no meaningful impact of the 1961 program 

(Modigliani and Sutch 1966). However, more recent studies that make use of a modern event 

study methodology have found a significant impact (Swanson 2011).14

Operation Twist is perhaps the best example of the potential for Fed and Treasury cooperation, 

because the circumstance was, much like the zero lower bound today, that the Fed was 

constrained in its use of the short rate as a policy instrument. However, unlike in the more recent 

period, during Operation Twist the Fed was able to complement its own actions with the secured 

cooperation of the Treasury to alter the maturity structure of new debt issuance.

14 Long-term interest rates fell on most dates in early 1961 when the initial information about Treasury and Fed 

policies was released. The only exception was when the Treasury surprised both the White House and the Fed by 

issuing longer-term bonds on March 15, 1961. This made James Tobin (then a member of Kennedy’s CEA) 

“furious.” Treasury continued to extend its maturity thereafter and within a year the average maturity had increased 

by 3.5 months. Thus, Treasury began working at cross-purposes with the Fed, just in as the current episode.

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B. International precedents

Beyond the historical evidence of cooperation in the United States, another relevant benchmark 

is practice across the major economies. 

Table 3 compares debt management practices across G-7 countries. The table highlights the wide 

variety of institutional arrangements adopted to coordinate debt management with monetary 

policy. In all countries in the G-7, debt management resides in the Treasury or a debt 

management office (DMO) controlled by the Treasury. While the comparison to Germany, 

France, and Italy is muddled by the fact that those countries do not have central banks that 

determine monetary policy, the experience of the other large countries is illustrative.

Upon hitting the zero lower bound and venturing into QE, two different paths emerge for policy 

coordination. One alternative is shown by Japan and the U.S., where debt managers extended 

maturity more aggressively than in any other G-7 country. Both countries lack any formal 

avenues for policy coordination between debt managers and central bankers. The other 

alternative is exemplified by the UK, where policymakers have a clearer record of coordinating 

debt management and monetary policy, perhaps because of the historical roles the Bank of 

England has played in both policy areas. The UK DMO is mandated to “ensure that debt 

management is consistent with the aims of monetary policy.” As the Bank of England was 

getting ready to begin QE in early 2009, its governor sent a public letter to the Chancellor of the 

Exchequer. The Bank of England claimed that in order to ensure consistency between debt 

management and monetary policy, the government should not alter its issuance strategy as a 

result of QE. The government confirmed that it would not alter its debt issuance strategy based 

on the Bank of England’s asset purchases. Indeed, the DMO shortened the average maturity by 1

year between March 2009 and March 2010. 

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Table 3

Debt Management in the G7: Coordination between the Central Bank and Treasury

The table describes, in brief, the pre-2008 arrangement, if any, for coordinating debt management between the central 

bank and Treasury. The “QE Era” columns describes how debt management has evolved in the years since the financial 

crisis. The rightmost column lists the average debt maturity in 2014. Data compiled by authors from various sources, 

including the OECD, the IMF Fiscal Monitor, Sundararajan, Dattels, and Blommestein (1997), and national finance 

ministry websites.

Country Pre-2008 Debt Management Arrangement QE Era

Average 

Maturity 

in 2014 

United 

States

There are no formal institutional 

arrangements to coordinate with monetary 

policy. Treasury has full authority over U.S.

debt management. The Fed tends to mimic 

Treasury issuance patterns and only target 

short rates (with some exceptions, such as 

WWII and 1961 Operation Twist).

Treasury extended its debt maturity to 

reduce rollover risk and catch up with 

other countries. The side effect was to 

counteract a portion of Fed’s QE effects. 

It is not clear which agency controls the 

U.S. government maturity policy.

5.7 years

Canada Debt management resides in the Ministry of 

Finance. The Canadian Finance Department

formally consults with the Bank of Canada on 

debt management decisions and issuance 

schedules are announced on the Bank of 

Canada’s website. In policy reports, there is 

discussion of the shared responsibilities and 

joint efforts of the Ministry and the Bank.

In the decade before the crisis, Canada’s 

average maturity moved very slowly within 

a range of 6.0 years to 7.0 years. During the 

crisis, however, average maturity fell from 

7.0 years in 2007 to 6.0 years in 2009, as 

bills were used to fund both fiscal deficits 

and the government’s MBS purchase 

program. In 2012 the government

announced that it would reallocate issuance 

towards long-term bonds to reduce 

refinancing risk.

6.0 years

France There are no institutional arrangements to 

coordinate with monetary policy. In 2000, the 

Agence France Trésor was created within the 

Finance Ministry to manage the debt. The 

idea of an independent office was rejected on 

the grounds of democratic accountability and 

linkages to fiscal policy.

Maturity of French debt is currently at 

approximately the same level as it was in 

2006 and 2007.

7.0 years

Germany There are no institutional arrangements to 

coordinate with monetary policy. From 1997 

to 2011, Germany’s debt managers held the 

government’s average maturity near 6.0 years. 

In 2001, debt management was taken out of 

the Finance Ministry and given to a private 

company to be wholly owned by the Finance 

Ministry. 

In 2012, Germany’s debt managers joined 

the international trend towards 

lengthening, increasing the average 

government debt maturity by nearly one 

full year since then (from 5.6 years in 

2011 to 6.5 years in 2014). This has been 

the largest 3-year shift in Germany’s 

average maturity seen in the past 15 years.

6.5 years

September 30, 2014 21
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Table 3 (continued)

Debt Management in the G7: Coordination between the Central Bank and Treasury

Country Pre-2008 Debt Management Arrangement QE Era

Average 

Maturity 

in 2014 

Italy The Italian Treasury has the authority over 

debt management. However, the Bank of Italy 

advises the Treasury on debt management. In 

its advisory capacity, the Bank of Italy takes 

into account monetary conditions.

The average maturity of Italian government 

bonds has decreased by nearly 1 year since 

2009. However, this may be more due to 

sovereign credit pressures than an attempt 

to ease monetary conditions. In 2014, the 

Italian Treasury has been trying to issue 

longer-term. 

6.3 years

United 

Kingdom

In 1997, when the government gave the Bank 

of England independent control over interest 

rates, debt management policy was also taken 

out of the Bank of England to avoid any 

perceived conflicts with monetary policy. 

Debt management was assigned to the newly 

established Debt Management Office (DMO), 

an executive agency of Treasury. However, 

the DMO must “ensure that debt management 

is consistent with the aims of monetary 

policy.”

As the Bank of England began its 

quantitative easing program in early 2009, 

the Governor of the Bank of England sent 

a public letter to the Chancellor of the 

Exchequer that in order to ensure 

consistency between debt management 

and monetary policy the government 

should not alter its issuance strategy in 

response to QE. The directive was 

accepted by the Chancellor.

14.9 

years

Japan An office within the Ministry of Finance 

determines which maturities to issue, with a 

goal of ensuring smooth and cost-effective 

issuance. The central bank acts as fiscal agent 

but the Ministry announces all issuance plans 

and auction results. There is no special 

committee or working group to ensure 

coordination between debt management and 

monetary policy, despite both being actively 

involved in bond markets.

Bank of Japan has been engaged in a large 

quantitative easing program since 2010. 

Debt management since 2009 has been 

aggressively extending maturity to reduce 

rollover risk associated with large debt 

levels. The conflicting tactics of monetary 

policy and debt management are similar 

to the U.S., except that in Japan, rollover 

risk may loom larger than refinancing 

risk.

7.7 years

September 30, 2014 22
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III. THE OPTIMAL MATURITY STRUCTURE OF THE NET 

CONSOLIDATED GOVERNMENT DEBT

In this section we argue that modern debt management has four competing policy objectives: (1) 

financing the government at the lowest cost, (2) minimizing fiscal risk, (3) managing aggregate 

demand, and (4) promoting financial stability. For each of these objectives, it is the composition 

of the government’s net consolidated debt (publicly held Treasury debt plus interest-bearing 

Federal Reserve liabilities minus Fed holdings of Treasury debt) that matters. The composition of 

the net consolidated debt is the key instrument of debt management policy because it summarizes 

the set of government liabilities held by the private sector and accounts for the fact that the 

Federal Reserve remits its profits to the Treasury.

15

We first use this framework to address the central decision of debt management policy—namely 

the optimal maturity structure of the debt. In Section IV, we then turn to other aspects of debt 

management policy, including the optimal mix between nominal and inflation-linked debt and 

how to capture the “on-the-run” liquidity premium. Finally, in Section V we discuss the optimal 

implementation of this strategy and the question of the appropriate division of labor between the

Treasury and the Federal Reserve.

A. The Ricardian equivalence benchmark

Theories of optimal government debt management hinge on failures of “Ricardian equivalence.” 

Ricardian equivalence is the public finance analog of the Modigliani-Miller (1958) irrelevance 

theorem, which states that—under certain strict conditions—the way that a corporation finances 

itself has no effect on the firm’s total value. Analogously, Ricardian equivalence says that the 

manner in which the government finances its expenditures using taxes and various types of debt 

has no effect on household consumption and well-being if: (1) taxation creates no deadweight 

losses, (2) government debt is valued solely for its cash flows in different states of the world 

(i.e., private agents do not derive liquidity services from holding government debt in the same 

way that they derive services from holding base money), and (3) capital markets are frictionless 

(Barro 1974). 16 If Ricardian equivalence holds, then not only is debt management (i.e., the 

maturity structure of the debt) irrelevant, but deficit spending is also irrelevant.

15 In other words, in a regime with interest on reserves, T-bills and reserves are very close substitutes. This is a 

simplification because, unlike T-bills, reserves are base currency and thus may have additional transactional value. 

However, these distinctions are trivial in the QE era, because the demand for reserves is satiated.

16 More formally, the assumption that capital markets are frictionless means that any agent’s marginal utility of 

income (stochastic discount factor) must price all financial assets in the same way. However, markets need not be 

complete so their need not be a unique stochastic discount factor and risk-sharing across agents need not be perfect. 

However, there cannot be important constraints to participating in financial markets, borrowing constraints, shortselling constraints, agency frictions, or other forms of market segmentation which lead agents to assign different 

September 30, 2014 23

 
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A simple example illustrates the power of the Ricardian benchmark for debt management. 

Consider a government with an initial accumulated deficit and no future expenditures that must 

decide whether to finance the deficit by issuing short- or long-term bonds. If the government 

finances itself solely through the issuance of short-term debt, then the government will have to 

raise taxes if short-term interest rates rise. However, the rise in interest rates will leave a 

household that is lending short-term to the government with a bit more in its bank account. Since 

the government’s sources of funds (taxes and proceeds from issuing new debt) must equal its 

uses of funds (paying off maturing debt), the gain in the household’s bank accounts must 

precisely offset the increase in taxes. As a result, issuing more short-term government debt 

increases the interest rate exposure of households’ future tax liabilities, but has a perfectly 

offsetting effect on the value of its portfolio of bond holdings. It follows that the government 

should be completely indifferent between issuing short- or long-term debt. This reflects the 

deeper point that, in a Ricardian world, government debts are not a form of “net wealth” for 

private actors; they simply reflect the present value of future tax liabilities.

To reach these striking conclusions, the Ricardian benchmark relies on a number of strong 

assumptions. Modern debt management policy hinges on four important real-world deviations 

from these assumptions. First, certain types of government debt are “net wealth” in the sense that 

they offer investors a valuable set of liquidity services above and beyond their financial cash 

flows in different states of the world. By liquidity services we mean providing transactional

services or relaxing constraints that would otherwise restrict investors. Krishnamurthy and 

Vissing-Jorgensen (2012) find strong evidence that Treasury securities offer valuable liquidity 

services and, thus, embed a significant “liquidity premium.” For example, Treasury bills appear 

to provide investors with many of the same liquidity and storage services as base money. As a 

result, the yields on T-bills appear to be lower than they would be in the absence of these 

valuable monetary services (GHS). Recognizing these benefits, the government can improve 

welfare by issuing debt securities that offer investors these special liquidity services.

Second, debt management may play an important role in managing fiscal risk. A standard 

rationale for fiscal risk management stems from the insight that government taxation distorts 

private incentives, creating deadweight costs. It is natural to think that the deadweight cost of

taxation is a convex function of the level of taxes. This implies that, all else being equal, society 

is best off when taxes are low and smooth over time (Barro 1979; Stokey and Lucas 1983). By 

insulating the budget from the refinancing risk associated with a very short-term maturity 

structure, prudent debt management may play a valuable role in smoothing taxes. Going further, 

rolling over too much short-term debt might even make the government vulnerable to bank-run 

problems, whereby a growing fear about the government’s ability to service its debts leads to a 

sharp rise in interest costs and makes the fear self-fulfilling (Bohn 2011). However, a variety of 

values to the same asset. Proofs of Ricardian equivalence also assume that agents have infinite horizons and this is 

often cited as a reason why Ricardian equivalence may fail. However, lifetimes are long enough that finite lifetimes 

cannot account for meaningful failures of Ricardian equivalence (Poterba and Summers 1987).

September 30, 2014 24

 
Hutchins Center Working Paper #5

political economy factors suggest that managing the debt to limit the volatility of the 

government’s interest bill may be desirable for reasons beyond tax smoothing and avoiding runlike spirals. For instance, a natural aversion to deficit financing, even if short-lived, means that 

temporary fiscal shocks may lead to large cuts in valuable government programs.17

Third, real-world capital markets operate with a variety of frictions not envisioned in the 

Ricardian benchmark. The most important friction from the perspective of debt management is 

the segmentation of capital markets, which suggests that the marginal holder of a given financial 

asset is a typically specialized investor who is more exposed to that asset’s idiosyncratic risks 

than the average taxpayer. This segmentation explains why policies such as quantitative easing 

can influence the prices of financial assets and can therefore function as a tool for managing 

aggregate demand. Specifically, shortening the maturity of the net government debt causes 

specialized fixed-income investors to bear less interest rate risk, and may therefore lower the 

long-term interest rates relative to short-term rates. Quantitative easing is done in the belief that 

such interest rate changes are passed through to private borrowers, helping to stimulate long-term 

corporate investment, residential construction, and spending on consumer durable goods.

Fourth, because private financial intermediaries can also create money-like short-term debt, debt 

management policy may be able to alter the behavior of intermediaries so as to promote financial 

stability (GHS; Krishnamurthy and Vissing-Jorgensen 2013; Pozsar 2011, 2012). Specifically, 

by issuing more short-term debt, the government can reduce the attraction of short-term debt for 

financial intermediaries. In this way, the government may be able to reduce the amount of 

liquidity transformation in the financial system, thereby limiting the likelihood and severity of 

future financial crises.

Below we develop a framework for government debt management that emphasizes the four realworld frictions outlined above. We start with the first two frictions and describe the model 

developed by GHS in which the government pursues a tradeoff between its desire to issue 

“cheap” securities that provide liquidity services and its desire to manage fiscal risk. This simple 

tradeoff model captures the essence of the traditional debt management problem, as framed by 

Treasury officials: how to finance the public debt at the lowest cost while being prudent from the 

perspective of fiscal risk.

We then extend the model to consider the two non-traditional goals of debt management 

suggested above: promoting financial stability and managing aggregate demand. Although these 

two policy goals are hardly new, the idea of using debt management policies to pursue them has 

only emerged in recent years. Because our model already considers a tradeoff between 

competing government objectives, it is well-suited for analyzing these nontraditional objectives 

of debt management.

17 For instance, Auerbach and Gale (2009) find that, controlling for the difference between actual and potential 

GDP, roughly one-quarter of the annual change in the Federal deficit from 1984 to 2009 was offset by policy, with 

changes in outlays accounting for slightly more of the response than changes in revenues.

September 30, 2014 25

 
Hutchins Center Working Paper #5

Our framework suggests that optimal debt management hinges on a set of potentially 

quantifiable forces. Although a rigorous analysis of this sort is beyond the scope of the current 

paper, we provide some educated guesses regarding the likely magnitude of the relevant forces, 

as well as describing how these forces may vary over time. Taken together, we argue that over 

the long-run, the optimal maturity structure of government debt may be shorter than the 

government has entertained historically. We explore this idea by describing a counterfactual 

financing history of the federal government in which the government relies on a much shorterterm funding mix in the post-war era. We also argue that the optimal maturity structure of debt 

may vary over time, in a direction that is correlated with the path of monetary policy. In the last 

section of the paper, we turn to what this means for coordination between the Fed and Treasury.

B. A trade-off model of government debt maturity

GHS consider a government that trades off a desire to issue “cheap” securities versus a desire to 

manage fiscal risk. For the time being, we focus on the optimal maturity structure of the debt and 

postpone other facets of debt management to Section V.

This trade-off framework captures the essence of the debt management problem as described by 

Treasury officials. For instance, in 1998 Assistant Secretary Gary Gensler emphasized the 

importance of “achieving the lowest cost financing for taxpayers.” At the same time, he noted 

that, “Treasury finances across the yield curve” because “a balanced maturity structure mitigates 

refunding risks.” Ten years later, in 2008, Director of the Office of Debt Management Karthik

Ramanathan echoed that sentiment, stating that the primary objective of debt management was to 

achieve the “lowest cost of financing over time,” while emphasizing that it is crucial to “spread 

debt across maturities to reduce risk.”

What does it mean to issue “cheap,” or to achieve “the lowest cost financing over time”? It 

cannot simply mean issuing securities with a low current yield-to-maturity. A clear reason why is 

the expectations hypothesis of interest rates: short-term rates may be low compared to long-term 

rates because short-term rates are expected to rise in the future. In this case, issuing short term

rates, while resulting in low current interest payments, is likely to lead to higher interest 

payments in the future, implying that the government should be indifferent between rolling over 

short-term debt and issuing long-term debt.

However, the nature of what ought to count as “low cost” goes beyond simply adjusting for the 

expected path of future short-term interest rates. For instance, if long-term bonds offer a higher 

expected return than short-term bonds simply because longer-term bonds are riskier in the 

frictionless asset-pricing sense—i.e., if the returns on long-term bonds tend to underperform 

those on short-term bills in bad economic times when the typical household’s marginal utility of 

income is high, then this is not a coherent policy rationale for issuing short. In this case, we are 

back to the standard Ricardian result, where the government cannot make households better off 

by changing around its maturity mix. This is because in a Ricardian world such a debt 

September 30, 2014 26
Hutchins Center Working Paper #5

management strategy shifts risk between households’ government bond portfolios and their tax 

liabilities, but leaves households bearing the same total amount of interest rate risk.

A role for debt management arises if there is a special, non-risk-based demand for particular 

types of government securities—i.e., if different securities provide different amounts of liquidity 

services, leading their yields to embed differential liquidity premia.

18 GHS argue that short-term 

Treasury bills typically embed a larger liquidity premium than long-term Treasuries because bills 

provide more of the valuable services offered by traditional money (e.g., tremendous liquidity 

and absolute safety as a near-term store of value).

19

However, when debt managers say they are trying to achieve the lowest cost financing for 

taxpayers, we sense that they have more in mind than capturing differential liquidity premia. 

Specifically, it seems that—all else being equal—debt managers might prefer a shorter average 

maturity for the debt in order to conserve on the “term premium” that compensates long-term 

bond investors for bearing interest rate risk. 

Is economizing on the term premium a coherent rationale for shortening the average maturity of 

the debt? If markets are frictionless, and all households assign the same value to long-term 

bonds, then the answer is a clear “no,” as explained above. However, if markets are segmented, 

meaning long-term bonds are priced by specialized bond investors who are more worried about 

interest rate risk than the typical taxpayer, then the government can make the typical taxpayer 

better off by borrowing short.20 Since this same segmented market logic underlies the portfolio 

balance channel of QE, conserving on the term premium may be a defensible rationale for 

lowering the average maturity of the debt.21

Turning to the other side of the tradeoff, the government also seeks to minimize fiscal risk, 

meaning that the cost of servicing the debt should not be too volatile. Issuing too much shortterm debt exposes the government to the possibility that interest rates may rise. The formal 

justification for fiscal risk management in GHS is that government should try to avoid budget 

18 If all forms of government debt provide the same amount of liquidity services, then Ricardian equivalence fails,

and the overall quantity of government debt will matter; however, the composition of the debt—i.e., debt 

management policy—would be irrelevant. 19 As we discuss in Section V, there are also circumstances in which certain long-term securities embed a differential 

liquidity premium. Most famously, “on-the-run” notes and bonds often trade at lower yields than off-the-run notes 

and bonds with nearly identical cash flows (Warga 1992; Fleming 2000; Krishnamurthy 2002). More recently, 

several studies have found that nominal government debt typically embeds a significant liquidity premium relative 

to inflation-indexed debt (Campbell, Shiller, and Viceira 2009; Fleckenstein, Longstaff, and Lustig 2013; and 

Pflueger and Viceira 2013). Finally, Greenwood and Vayanos (2010) find that long-dated UK government bonds 

trade at a special premium due to hedging demand by British pensions.

20 If markets are segmented, the expected tax savings from conserving on the term premium demanded by 

specialized bond investors can more than compensate the typical taxpayer for the additional tax volatility. 21 For instance, in 1993 some of President Clinton’s economic advisers argued that it would be desirable to shorten 

the average maturity of the government debt (Wessel 1993). First, they argued that this would reduce the 

government’s interest bill over time by conserving on term premia. Second, they argued that the reduction in supply 

would lower term premia via a portfolio balance channel, thereby depressing long-term private borrowing rates.

September 30, 2014 27

 
Hutchins Center Working Paper #5

risk because this directly leads to volatility in tax rates. And, because the marginal deadweight 

costs of taxation are increasing in the level of taxes—i.e., the costs are convex—this generates a 

desire to smooth taxes over time.

The reasons to minimize fiscal risk likely go well beyond any deadweight costs associated with 

volatile taxes. For example, a very short-term maturity structure might make the government 

vulnerable to bank-run problems. Furthermore, one may want to limit budget volatility to avoid 

cutting valuable government programs in the face of temporary negative shocks. 22

For the sake of concreteness, we introduce a simplified version of the model in GHS. Consider a 

government with an initial accumulated debt (D), and no future expenditures, that must finance 

itself through a combination of short-term bonds, long-term bonds, and taxes. Let S denote the 

fraction of the debt that is short-term and 1–S the fraction that is long-term.

Suppose there is a special demand that makes it cheap to issue short-term debt because shortterm debt offers more the same services as base money: tremendous liquidity and absolute safety 

as a store of value. It is natural to assume that the demand for these monetary services is 

downward sloping, so the money-like premium on short-term debt is decreasing in the total 

amount of short-term debt (SD). We assume that debt managers take the path of short-term 

interest rates (i.e., conventional monetary policy) as given, but recognize that their issuance 

decisions may impact the liquidity premium on short-term debt.

On the one hand, this liquidity premium makes the government want to issue more short-term 

debt. On the other hand, because the government must refinance this short-term debt at an 

uncertain future interest rate, issuing more short-term debt exposes taxpayers to refinancing risk

and makes future taxes more volatile, which is costly. Specifically, a spike in interest rate would 

lead tax rates to jump. However, in a more general sense, such a shock to the budget might lead 

to a combination of tax increases and spending cuts, both of which would be painful.

22 An aversion to deficit financing, even if temporary, may be a natural response to agency or informational 

problems between taxpayers and their elected representatives. In the US, such an aversion to deficit financing has 

been formalized through the use of pay-as-you-go budgeting rules, which mandate that statutory spending or tax 

changes cannot add to the deficit. While formal PAYGO rules only apply prospectively to new spending 

authorization or changes in tax policy, it seems plausible to think that using deficit financing to optimally smooth 

large temporary shocks to the interest bill over time may also be politically infeasible.

September 30, 2014 28

 
Hutchins Center Working Paper #5

Formally, assume that the liquidity premium on short term debt is γ, that the deadweight costs of 

taxation are (λ/2)τ

2

, and that the variance of short-term interest rates is Vr. If the government 

finances itself by issuing fraction S of short-term debt and (1–S) of long-term debt, it captures a 

total money premium benefit of γSD. At the same time, this raises the volatility of taxes, which 

have costs (λ/2)Var[τ] = (λ/2)D2Vr (S – S0)

2 where S0 is a small number that reflects the maturity 

structure that minimizes fiscal risk in isolation. Thus, the optimal fraction of short-term 

government debt is

*

0

1 .

r

S S

D V

γ

λ

= + (3)

Absent a liquidity premium on short-term debt (γ = 0), the government immunizes itself against 

refinancing risk by opting for a long-term maturity structure, setting S = S0.

23 In contrast, if 

short-term securities trade at a special premium (γ > 0), so the government issues more shortterm debt, exposing taxpayers to greater refinancing risk in order to capture more of the liquidity 

premium. The larger the premium, the more aggressively the government relies on short-term 

debt. More generally, one could associate γ in equation (3) with other policy-relevant savings 

from issuing short term (e.g., with the component of the term premium that compensates 

specialized bond investors for bearing greater interest rate risk).

Similarly, when short-term interest rates are less volatile (Vr is low), or when budget volatility is 

less costly (λ is low), the more aggressively the government seeks to capture the liquidity 

premium on short-term debt. 24 In the limit, if there were no cost associated with budgetary 

volatility, then the government should continue to shorten the maturity of the debt until the 

special demand for short-term debt is satiated. In this limiting case, optimal debt management is 

generalization of the Friedman (1960) rule of monetary policy which says that, absent any costs, 

the Federal Reserve should expand the monetary base until the demand for money is satiated.

Equation (3) suggests that for larger values of accumulated debt, the government should issue 

longer term, with both sides of the key trade-off pointing in the same direction. First, as the 

overall debt burden grows, the fiscal costs associated with refinancing risk or the possibility of a 

23 There is a close analogy between equation (3) and the classic formula from the theory of portfolio choice. For an 

investor with a risk aversion of a, the optimal share in a risky asset whose excess returns have mean E[rx] and 

variance is w = E[rx]/(aV[rx]). Thus, the money premium (γ) in equation (3) corresponds to the expected excess 

return (E[rx]), the cost of tax volatility times the level of debt-to-GDP (λD) corresponds to the degree of risk 

aversion (a), and the variance of short-rate shocks (Vr) corresponds to the variance of excess returns (V[rx]). 24 In GHS, shortening the maturity structure has three logically distinct effects on household well-being. First, this 

directly raises household well-being because household derive liquidity services from holding money-like T-bills. 

Second, this raises the volatility of future taxes, which reduces well-being. Third, this lowers taxes today because 

selling T-bills that embed a liquidity premium provides the government a form of seignorage revenue. If raising tax 

revenue is distortionary, but raising seignorage revenue is not, this adds another force to those summarized in 

equation (3). However, if raising all forms of government revenue—whether through taxes or seignorage—is 

distortionary, this tax-lowering consideration disappears.

September 30, 2014 29

 
Hutchins Center Working Paper #5

debt rollover crisis loom larger. Second, because the demand for liquidity services is downward 

sloping, the liquidity premium on short-term debt falls as D rises, further reducing the incentive 

to tilt towards short-term debt.

Consistent with this trade-off view, the U.S. has had a strong tendency in the post-Accord era to 

extend the maturity of the public debt as the overall debt burden grows. Figure 6 plots the 

fraction of outstanding debt that is long term (defined as maturing in more than 5 years) against 

the debt-to-GDP ratio from 1952 to 2013. The two series are strongly positively correlated

(correlation coefficient of 0.71). This relationship between debt maturity and debt-to-GDP is one 

of the most direct implications of the trade-off model.25 It is precisely this view that explains 

why the Treasury lengthened the maturity of its debt beginning in 2009. The Treasury Borrowing 

Advisory Committee suggested in November 2009 that “the potential for inflation, higher 

interest rates, and roll over risk should be of material concern.... lengthening the average 

maturity of debt from 53 months to 74–90 months was recommended.”

How large is the special liquidity premium embedded in short-term T-bills? And why might Tbills provide greater liquidity services that longer-term notes and bond? Krishnamurthy and 

Vissing-Jorgensen (2012) argue that all Treasuries have some of the same features as traditional 

money, namely liquidity and absolute safety. They find that the liquidity services associated with 

these special attributes lead Treasuries to have significantly lower yields than they otherwise 

would. Their estimate of the liquidity premium on Treasuries from 1926 to 2008 is 73 basis 

points. 26 However, Krishnamurthy and Vissing-Jorgensen suggest that short- and long-term 

Treasuries offer very different types of safety, and so are unlikely to be perfect substitutes. Tbills provide short-term safety: the absolute stability of near-term market value. While long-term 

Treasuries offer long-term safety in the sense of absolute certainty of repayment, they are 

nevertheless subject to interim market risk. Consistent with the existence of a special demand for 

short-term safety, the yields on short-term T-bills are often quite low relative to those on longerterm notes and bonds (Amihud and Mendelson 1991, and Duffee 1996). GHS confirm this by 

comparing actual T-bills yields with “fitted yields” based on a flexible model of the Treasury 

yield curve. Their analysis suggests that on average, from 1983 to 2009 4-week bills had yields 

that were roughly 40 basis points below their fitted values based on longer-term Treasuries.

Figure 7 illustrates the special money-like premium on very short-term Treasury bills. Panel A 

plots the yield on 1-month T-bills versus the 1-month overnight index swap (OIS) rate, which is 

a good proxy for the default-free short-term rate that does not benefit from these special liquidity 

25 The strong relationship between government debt maturity and debt-to-GDP is also noted by Greenwood and 

Vayanos (2014); Greenwood, Hanson, and Stein (2010); and Krishnamurthy and Vissing-Jorgensen (2012). 26 Krishnamurthy and Vissing-Jorgensen’s estimate is based on measuring the impact of changes in Treasury supply 

on a variety of yield spreads. For example, they show that an increase in Treasury supply reduces the spread 

between long-term Treasuries and AAA-rated corporate bonds and the spread between short-term Treasury bills and 

highly-rated commercial paper.

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Hutchins Center Working Paper #5

premia.27 Panel B plots the spread between the 1-month OIS rate and the 1-month T-bill rate. 

This spread reflects the special money-like liquidity premium on T-bills. GHS show that these 

convenience premia are particularly pronounced for very short-term bills such as those maturing 

in less than a quarter or a month.

Figure 6

Maturity Structure of the Public Debt and Debt/GDP

The solid line in this figure shows the percentage of Treasury debt that has a remaining maturity of 5 years or 

more. The dashed line shows the Debt-to-GDP ratio. Data were compiled from various issues of the Monthly 

Statement of the Public Debt, Treasury Bulletin, Banking and Monetary Statistics, and Federal Reserve 

Bulletin.

27 The OIS rate is unlikely to be affected by default risk since it is based on the expected overnight Federal funds

rate. And it is largely free of any convenience premium since it is not a rate at which a money market investor can 

invest principal (i.e., a swap is not a stable-value store of value in the same way as a T-bill or financial CP).

0%

20%

40%

60%

80%

100%

120%

1930 1940 1950 1960 1970 1980 1990 2000 2010

Long-term share Treasury Debt/GDP

September 30, 2014 31

 
Hutchins Center Working Paper #5

Figure 7

Estimates of Liquidity Premia on Treasuries

This figure shows estimates of the liquidity premia on short-term Treasury bills and nominal Treasuries. Panel 

A plots the yield on 1-month Treasury bills from the FRED database and the 1-month overnight index swap 

(OIS) rate from Bloomberg. Panel B plots the difference between the 1-month OIS rate and the 1-month T-bill 

rate which is a measure of the liquidity premium on Treasury bills. Panel C plots the yield on a synthetic 5-year 

zero coupon nominal Treasury—computed as the sum of the 5-year TIPS yield at the 5-year inflation swap 

yield—versus the actual 5-year zero coupon yield for nominal Treasuries. Panel D plots the difference between 

the synthetic nominal yield and the actual nominal yield which is an estimate on the liquidity premium on

nominal debt. Zero-coupon nominal Treasury and TIPS yields are from Gürkaynak, Sack, and Wright (2007, 

2010), and 10-year zero-coupon inflation swap yields from Bloomberg. In all four panels, we show the weekly 

moving averages of daily data.

Panel A: One-Month Interest Rates Panel B: Liquidity Premium on Short-Term T-Bills

Panel C: Five-Year Zero-Coupon Yields Panel D: Liquidity Premium on Nominals vs. TIPS

0

2

4

6

2002 2004 2006 2008 2010 2012 2014

%

1-month OIS 1-month T-bill

0

50

100

150

200

2002 2004 2006 2008 2010 2012 2014

bps

0

2

4

6

2004 2006 2008 2010 2012 2014

%

5-year Synthetic Nominal 5-year Nominal

0

50

100

150

200

2004 2006 2008 2010 2012 2014

bps

September 30, 2014 32
Hutchins Center Working Paper #5

There is strong evidence that shifts in these liquidity premia are driven by shifts in the demand 

and supply of money-like assets. Specifically, Krishnamurthy and Vissing-Jorgensen (2012) and 

GHS (2014) find that shifts in T-bill supply due to movements in the debt-to-GDP ratio can 

explain much of the low-frequency variation in the liquidity premia on T-bills. Nagel (2014) 

argues that shifts in the demand for money-like debt associated with changes in the level of 

short-term nominal interest rates explains much of the business-cycle frequency variation in 

these premia. Specifically, demand for money-like debt and hence liquidity premia are high 

when short-term interest rates are high. This pattern is clearly evident even in the short timeseries below. 28 At higher frequencies, the variation in these spreads is explained to seasonal 

fluctuations in T-bill supply (GHS) and week-to-week shifts in the institutional demand for 

money-market investments, as well as flight-to-quality episodes (Sunderam 2014).

How large are the fiscal risk costs associated with issuing more short-term debt? In the GHS 

model, fiscal costs coming from the deadweight costs of taxation are (λ/2)τ

2

, so the marginal 

deadweight cost is λτ. A conservative upper bound on the marginal deadweight cost is 0.5 

(Chetty 2012). Assuming a tax-rate of roughly 25 percent, this implies an upper bound of λ = 2. 

Thus, the costs of distortionary taxation are no greater than E[τ

2

] = (E[τ])2 + Var[τ]. Assuming 

E[τ] = 25 percent, this implies that (E[τ])2 = 6.25 percent. However, the component of Var[τ] 

driven by fluctuations in interest rates is likely an order of magnitude smaller. In other words, 

plausible estimates of the welfare costs from the failure to smooth taxes over time are tiny.

Although emphasized by GHS in their formal model, thinking of fiscal risk as solely the 

distortionary costs of taxation is probably too limited. Consider the following back-of-theenvelope calculation. Suppose all the debt is short term and is refinanced once each year. Then, 

at the current debt-to-GDP ratio of 70 percent, a 1 percentage point increase in short-term real 

interest rates raises the ratio of interest expense to GDP by 0.70 percent, or $120 billion based on 

2014Q2 GDP of $17.3 trillion. This is not a trivial shock to the Federal budget, exceeding the 

projected 2014 outlays of the Departments of Homeland Security ($50 billion), Education ($65 

billion), Labor ($75 billion), and Transportation ($80 billion). An unlikely 5 percentage point 

increase in short-term real rates would raise interest costs by 3.5 percent of GDP, or by $600

billion, exceeding the projected 2014 outlays for the Department of Defense ($595 billion). 

Calculations of this sort have often been used to motivate a strategy of extending the maturity of 

the debt (Cochrane 2012). 

28 Nagel’s (2014) argument is that short-term debt is a partial substitute for traditional forms of money such as 

currency and checking deposits. Since traditional money pays little or no interest, the nominal interest rate is the 

opportunity cost of holding money. Similarly, the liquidity premium—e.g., the difference between the yield on an 

illiquid short-term deposit and the yield on liquid short-term debt—is the opportunity cost of holding money-like 

short-term debt. All else equal, this suggests that savers will want to hold less traditional money and more moneylike short-term debt when short-term interest rates rise. Consistent with this view, savings tend to flow out of noninterest-bearing checking accounts and into money market funds when short-term interest rates are high.

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Hutchins Center Working Paper #5

Common sense suggests that the government might be willing to pay some insurance premium to 

avoid such scenarios. For instance, suppose we pay an additional 0.20 percent in interest on the 

debt to keep the interest expense smooth. In dollar terms, an annual premium of $25 billion [= 

$17.3 trillion × 70% × 0.20%] could insure against potential budgetary shocks of the magnitude 

described above. 

However, even if the government is willing to pay some insurance premium to reduce fiscal risk, 

there are two important reasons to think that the government may be able to take advantage of 

the large liquidity premium on short-term bills without incurring much additional risk. First, 

substituting 6-month T-bills, for which liquidity premia may be quite modest, with 1-month bills, 

for which liquidity premia are higher, may allow the government to capture the liquidity 

premium without significantly increasing overall budget volatility (assuming this would not 

make the government more vulnerable to debt rollover crisis).

Second, issuing short-term debt may be a natural hedge for fiscal shocks to the primary budget 

deficit. Specifically, the only source of fiscal risk in the baseline GHS model is due to 

uncertainty about the path of future short-term interest rates. However, debt managers also deal 

with volatility from the budgeting process that increases the overall debt burden. Consider the 

case where government debt managers are uncertain about both the path of future short-term 

interest rates as well as future primary fiscal deficits. In this regard, the existence of automatic 

stabilizers—the fact that government tax proceeds tend to fall and transfer payments tend to rise 

in recessions—suggests that that primary fiscal deficits will tend to be high recessions when 

short-term interest rates are low. This adds an additional fiscal hedging motive for issuing shortterm debt. The idea is that the cost of refinancing short-term debt tends to be low in states when 

primary deficits are high. Specifically, adapting the baseline GHS model, it is straightforward to 

show that the optimal fraction of short-term government debt is

1 * ,

0

1 , G r

r

S S

DV D

γ β

λ

=+ − (4)

where βG,r is the coefficient from a regression of unexpected future government deficits (G) on 

short-term real rates (r).29 Since we expect βG,r < 0, this fiscal hedging motive should push the 

government to adopt even short-term debt maturity structure.

C. Debt management and aggregate demand

Policymakers have tended to see monetary policy as separate and distinct from debt

management. However, the clean lines of demarcation between these branches of policy have 

been blurred since 2008. The Fed’s quantitative easing policies, which have swapped long-term 

Treasuries for short-term interest-bearing reserves, have shortened the maturity of the net 

29 Equation (4) follows from the observation that with, an unknown future deficit of G, we have 

(λ/2)Var[τ] = (λ/2)[VrD2

(S – S0)

2 + VG + 2D(S – S0)CG,r] where VG = Var[G] and CG,r = Cov[G,r].

September 30, 2014 34

 
Hutchins Center Working Paper #5

consolidated debt held by the public.30 Fed officials have argued that shortening the maturity of 

the consolidated public debt should lower the general level of long-term interest rate relative to 

short-term rates, thus stimulating long-term investment and consumption. In other words, the 

maturity structure of the public debt may be a tool of aggregate demand management. 

Furthermore, this may be one of the only available tools for combatting high unemployment and 

the threat of price deflation once nominal interest rates reach the zero lower bound.

Holding fixed the path of short-term interest rates and the total size of the debt, how can the 

average maturity of government debt affect long-term interest rates? The idea is that a reduction 

in government debt maturity lowers the amount of interest rate risk that fixed income investors 

have to bear, leading to a decline in the term premium—i.e., the difference in expected returns 

between long- and short-term bonds—due to a Tobin-style portfolio balance effect (Tobin 1958). 

Thus, the relevant summary statistic for such portfolio-balance policies would be the weighted 

average (or total dollar) duration held by private, fixed-income investors.31

Of course, in a frictionless Ricardian world, debt maturity would have no impact on term premia 

or on aggregate demand. This is because a market operation (whether conducted by the Treasury 

or the Fed) that, say, purchased long-term bonds and sold short-term bonds would not change the 

total amount of interest rate risk born by households: it would simply shift risk from households’ 

asset holdings to their tax liabilities (Wallace 1981, Eggertsson and Woodford 2003).

The strong evidence that debt management policies do impact term premia suggests that interest 

rate risk that is borne by investors directly through bond markets looms larger than interest rate 

risk that is borne indirectly by taxpayers.32 As noted above, the most natural explanation for this 

non-Ricardian result is that the marginal investor in bonds is a specialized, fixed-income investor 

who is far more heavily exposed to interest rate risk than the typical taxpayer. Thus, a reduction 

in the duration of government debt only succeeds in lowering term premia because it asks the 

typical taxpayer to bear a tiny bit more interest rate risk, so that the marginal bond investor can 

bear much less risk (Woodford 2012; Greenwood and Vayanos 2014; and Hanson 2014).

30 Technically, QE can be thought of as combination of a “conventional monetary easing” in which the Fed expands 

the supply of bank reserves by purchasing T-bills and an Operation Twist in which the Fed sells T-bills and buys 

long-term Treasuries. The conventional easing component has no effect at the zero lower bound, so the entire effect 

must come from the Operation Twist component (Woodford 2012). 31 In the formulation of this idea by Vayanos and Vila and Greenwood and Vayanos, term premia are proportional to 

the product of interest rate risk and dollar duration, scaled by the risk tolerance of bond investors (Vayanos and Vila

2009; Greenwood and Vayanos 2014). 32 See Greenwood and Vayanos (2014) for comprehensive evidence from the post-war era. See also Gagnon, Raskin, 

Remache, Sack (2010); Krishnamurthy and Vissing-Jorgensen (2011); Jarrow and Li (2012); and Li and Wei (2013) 

for appraisals of the Fed’s recent LSAP programs. See Bernanke, Reinhart, and Sack (2004); Greenwood and 

Vayanos (2010); and Swanson (2011) for event study evidence pre-dating the LSAPS. Relatedly, Hanson (2014) and 

Malkhozov, Mueller, Vedolin, and Venter (2014) provide strong evidence that shifts in the duration of US mortgage 

backed securities move bond term premia, even though they would have no effect if markets were frictionless.

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D. Debt management as a financial regulatory tool

Financial regulation and debt management have historically been seen as separate spheres of 

policy. However, GHS argue that the desire to promote a stable financial system should push the 

government further toward a shorter-term maturity structure.

To understand the argument, note that the government is not the only entity that can create 

riskless money-like short-term debt. Specifically, Gorton (2010), Gorton and Metrick (2012), 

Stein (2012a), Krishnamurthy and Vissing-Jorgensen (2013), and Pozsar (2011, 2012) argue that 

when financial intermediaries issue money-like short-term debt that is collateralized by longterm risky assets, they are engaged in liquidity creation. In this way, they capture some of the 

same liquidity premium as the Treasury does when it issues T-bills. While some amount of 

private liquidity transformation is desirable, the incentives for private liquidity creation are likely 

excessive because individual intermediaries do not take into account the full financial stability 

costs that are generated by their use of short-term funding. Put differently, liquidity 

transformation generates negative externalities, so government policies that work to reduce 

intermediaries’ over-reliance on short-term funding may be desirable. And, private liquidity 

transformation may be hard to regulate, particularly if it is done by the shadow banking sector.

What role can the government play through debt management? The government may “crowdout” some private sector short-term issuance by shortening its own maturity structure. The idea is 

that an expansion in T-bill supply would lower the premium on short-term money-like debt and 

reduce the temptation for private intermediaries to issue short. Of course, this policy response is 

not without cost since it generates additional fiscal risk. Thus, it is not optimal for the 

government to issue so much short-term debt as to completely counteract intermediaries’

tendency to over-rely on short-term funding. Said differently, the government should keep 

shortening its maturity as long as it has a comparative advantage over the private sector in the 

production of money-like short-term debt.

This line of thinking adds a regulatory dimension to debt management. Of course, another way to 

address the financial stability externalities associated with private liquidity transformation would 

be to regulate short-term private liabilities (Cochrane 2014; Ricks 2013). Private liquidity 

transformation could be directly controlled using a regulatory cap as under the Basel III bank 

liquidity regulations, or using a Pigouvian tax, as suggested by Stein (2012a) and Kashyap and 

Stein (2012). However, to the extent that direct regulation simply pushes liquidity transformation 

into the unregulated shadows, there will be a complementary role for a debt management policy.

Specifically, by impacting the liquidity premium on short-term debt, debt management can 

influence private sector incentives to engage in liquidity transformation, reaching into corners of 

the financial markets that lie beyond the grasp of regulators. In other words, the advantage of

debt management over direct regulation is that it “gets in all the cracks” (Stein 2013b).

September 30, 2014 36
Hutchins Center Working Paper #5

GHS argue that this crowding-out motive for issuing short-term T-bills may be of the same order 

of magnitude as the direct motive for producing debt with the liquidity services highlighted 

above. Thus, when weighed against the fiscal risk costs of issuing additional short-term debt, this 

financial stability benefit may be sufficient to meaningfully shorten the optimal maturity 

structure of the government debt.

E. Quantitative assessment and debt counterfactuals

Taken together, the analysis suggests that the forces in favor of short-term debt appear to be 

larger than conventionally thought. Similarly, the arguments in favor of long-term debt appear to 

be weaker than often thought. Still, this does not provide much quantitative guidance as to 

whether the weighted average maturity of the debt should be 12 months, 60 months, or 120 

months. In this section, we take a simple approach to this question by describing the results of a 

counterfactual exercise in which we suppose that the government had relied much more heavily 

on short-term debt following the 1951 Accord.

We focus on the extreme case in which the government had financed the debt using 3-month Tbills, meaning that the entire outstanding debt would be refinanced four times per year. We start 

by noting that the change in the debt equals the primary deficit (outlays and net transfer 

payments minus total tax revenue) plus interest paid:

1 , Debt Debt PrimDef Interest tt t t =+ + − (5)

where Debtt refers to the public debt held at the end of the fiscal year t (including debt held by 

the Federal Reserve), PrimDeft refers to the primary deficit, and Interestt refers to interest paid, 

including coupons on notes and bonds and imputed interest on Treasury bills that do not pay a 

coupon. We obtain Debtt, and Interestt from the Office and Management and Budget, and use 

this to back out the primary deficit according to equation (5). Our data start in June 30, 1951 

(start of the 1952 fiscal year), to capture the start of the post-Accord period. All calculations for 

this section are provided in an online appendix.

Figure 8 shows the time-series of average interest payments, expressed as a percentage of GDP. 

Interest payments average 1.8 percent of GDP per year, reflecting an average effective nominal 

interest rate paid of 4.97 percent. Interest/GDP is quite smooth over time, with a standard 

deviation of only 0.72 percent. In part, this reflects the average long-term nature of the debt and 

the fact that debt-to-GDP has been moderate over much of this 1952–2013 sample. 

September 30, 2014 37
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Figure 8

Debt and Deficits under Counterfactual Debt Management Plans

The counterfactual exercise measures the path of deficits and debt supposing that the U.S. Treasury had 

financed itself using rolling 3-month Treasury bills starting in 1952. We use the identity:

1 , Debt Debt PrimDef Interest tt t t =+ + −

and data on debt and net interest payments to back out primary deficits. Debt held by the public is from the 

Office of Management and Budget, Net Interest Expense is also from the Office of Management and Budget. In 

the counterfactual case, starting in September 1952, we compute Net Interest as the compounded interest from 

rolling over 3-month Treasury bills over the government fiscal year. Interest rates are from the Federal Reserve 

of St. Louis. Panel A shows actual and counterfactual interest payments, scaled by GDP. For purposes of 

comparison, it also shows the path of primary surpluses and deficits (surpluses carry a positive sign). In Panel 

B, we combined interest payments and the primary balance to show the combined total surplus, in both the 

actual data and the counterfactual. In Panel C we show the debt burden, as a percentage of GDP, in the realized 

and counterfactual cases. 

Panel A: Actual and Counterfactual Interest Payments, and Primary Balance (% of GDP)

Panel B: Total Surplus in Actual Data and Counterfactual (% of GDP)

Panel C. Debt and Counterfactual Debt Burden (% of GDP)

-15

-10

-5

0

5

Percentage Nomainal 

1952 1962 1972 1982 1992 2002 2012

GDP

Actual Interest Payment Counterfactual Interest Payment Primary Balance

-15

-10

-5

0

5

1952 1962 1972 1982 1992 2002 2012

Percentage Nominal 

GDP

Int. + Pri. Balance (Actual) Int. + Pri. Balance (Counterfactual)

0

20

40

60

80

1952 1962 1972 1982 1992 2002 2012

Percentage Nominal 

GDP

Actual Total Debt Counterfactual Total Debt

September 30, 2014 38
Hutchins Center Working Paper #5

Our counterfactual exercise assumes a debt management strategy of continuously rolling over 3-

month Treasury bills. We assume that the actual short-term interest rates that have prevailed 

since 1952 would have also prevailed under this counterfactual strategy. In doing so, we ignore 

the fact that the path of short-term interest rates would likely have been slightly different due to 

the deviations from Ricardian equivalence discussed above. For instance, in the extreme, 

financing the government entirely with short-term bills might make the government susceptible 

to bank-run-like outcomes which could have a significant impact on interest rates.

We compute the effective annual interest rate under this counterfactual debt management policy, 

RCounterfactual, by compounding 3-month Treasury bill rates.33 We then compute counterfactual 

interest payments according to

1

Counterfactual Counterfactual Counterfactual

t tt Interest Debt R = − × . (6)

Modifying equation (5), this allows us to compute a counterfactual evolution of the debt stock

1 . Counterfactual Counterfactual Counterfactual Debt Debt PrimDef Interest t t = ++ − t t (7)

Thus, starting with the actual debt outstanding at the end of 1951, we can construct a 

counterfactual path for Interest/GDP and Debt/GDP, taking as given the government’s realized 

primary deficits.

Figure 8 shows that issuing short-term debt results in higher volatility of interest payments. The 

volatility of Interest/GDP is 0.84 percent under the counterfactual strategy, compared to 0.72

percent under the actual strategy. How should we evaluate these numbers? Panel A shows that 

the volatility of Interest/GDP—whether in the actual or counterfactual case—is quite small 

compared to the volatility in PrimDef/GDP, which has an annual time-series volatility of 2.54

percent. But a simple comparison of the time-series volatilities under different financing regimes 

does not suffice, because the net increase in the debt stock is the sum of interest payments and 

the primary deficit, meaning that a short-term financing policy can serve as a hedge against 

primary deficits. This is for the simple reason that the primary deficit tends to be larger when the 

economy is performing poorly, and is associated with low or declining short-term interest rates. 

The correlation between the 1-year interest rate and the primary deficit is -0.26. The correlation 

between the interest rate on 10-year bonds and the primary deficit is, on the other hand, not 

essentially zero.

33 We obtain month-end data on 3-month T-bill rates from the Federal Reserve Bank of St. Louis’s FRED database. 

To compute the interest paid on a fiscal year basis (the Federal government’s fiscal year runs from October 1 to 

September 30), we compute the effective annual rate as

RCounterfactual = [(1+r(Sept.))(1+r(Dec..))(1+r(March))(1+r(June))]1/4 – 1,

where the subscripts on the 3-month T-Bill rate indicate the relevant month-end.

September 30, 2014 39

 
Hutchins Center Working Paper #5

How much did the government save in this counterfactual financing strategy? Our calculations 

suggest the government would have saved 0.38 percentage points of GDP per year. Panel B 

shows that the cumulative interest savings would have meaningfully lowered the debt stock over 

time. By the end of the sample, the public debt was 71.3 percent of GDP, whereas in the 

counterfactual case, it was only 54.8 percent.

What this makes clear is that ex post, the government would have been better off financing its 

debt over the short term. But, to be clear, we are not suggesting that we should use this exercise 

as an estimate of the interest cost savings that would be obtained by shortening the maturity of 

the debt going forward. For one, in the 1980s, the U.S. experienced a decline in inflation that was 

unexpected by market participants, a situation unlikely to be repeated. Notwithstanding, Figure 3

shows estimated ex ante term premia as estimated by Kim and Wright (2005), which averaged 45 

basis points per annum on 5-year zero-coupon debt from 1989 to 2013. Second, the logic of our 

model suggests that the average savings we computed overstates that welfare benefits from 

adopting a shorter debt maturity profile. The reason is that some of the term premium on longterm bond is surely compensation for risk in the traditional frictionless, asset-pricing sense. 

However, the government is not making households any better off by issuing short-term to 

“economize” on this risk premium since this necessarily increases the interest rate exposure of 

household’s tax liabilities. Only the component of the term premium that is due to the fact that Tbills provide higher liquidity convenience services or stemming from segmented bond markets 

should count from a welfare perspective.34

In summary, the main messages we take from these counterfactual exercises are (1) that the 

additional budgetary volatility incurred by shifting the government debt into short-term securities 

is less than is commonly supposed, and (2) that doing this would have allowed the government to 

capture liquidity premia on an ongoing basis.

IV. DEBT MANAGEMENT BEYOND MATURITY STRUCTURE

This framework for debt management can be extended to accommodate a host of issues beyond 

the question of the optimal maturity structure. We briefly discuss these extensions here.

34 We have repeated this counterfactual exercise in real terms, meaning that we compute the real value of the debt 

and the real interest (both as it happened and in the counterfactual case in which the government rolled over shortterm debt). Expressed in real terms, the “interest burden” of the debt reflects a combination of shocks to real interest 

rates and inflation. Real interest payments are more volatile than nominal interest payments. The standard deviation 

in the counterfactual case is 1.97 percent, more than twice the standard deviation of actual interest paid (0.81

percent). Both series are still less volatile than real primary deficits, which have a standard deviation of 2.52 percent. 

The correlation between the real actual interest payment and the real primary deficit is not significantly different 

from zero. In the counterfactual case, however, the correlation between effective real interest payments and the 

primary deficit is -0.39. This can be compared to the -0.26 (above) correlation in nominal terms.

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A. The choice of nominal versus inflation-indexed debt

Consider first the choice between long-term nominal and inflation-indexed debt. To do so, we 

need to distinguish between shocks to real interest rates and the rate of inflation. The government 

can now issue short-term bonds (automatically inflation-indexed since we assume that 

uncertainty about inflation is minimal at short horizons), long-term nominal bonds, and longterm inflation-indexed bonds.

Suppose that government debt managers take path of inflation and short-term real rates as given. 

If short-term real interest rates tend to be high when inflation is high—as one would expect if the 

Federal Reserve follows a standard Taylor rule—then short-term debt and long-term nominal 

debt will be complementary from a fiscal risk perspective. Suppose for example that inflation is 

low, so that the real tax burden needed to service long-term nominal debt is high. Since shortterm real rates are likely to be low in such a state, this makes short-term debt a good hedge for 

long-term nominal debt.

Beyond these risk management considerations, there is strong evidence that long-term nominal 

Treasuries embed a significant liquidity premium relative to long-term Treasury InflationProtected Securities (TIPS), (Campbell, Shiller, Viceira 2009); Fleckenstein, Longstaff, and 

Lustig 2013; Pfleuger and Viceira 2013). 

How large is the premium on nominal versus inflation-indexed debt? Fleckenstein, Longstaff, 

and Lustig (2013) estimate an average liquidity premium of roughly 55 bps on nominal 

Treasuries compared to TIPS from 2004 to 2009.35 Pflueger and Viceira (2013) find similar 

magnitudes for the U.S., as well as from inflation-indexed debt in the UK. Both papers argue that 

this is not simply the capitalized value of future bid-ask spreads or other transaction costs. 

Instead, it appears to reflect a special liquidity premium.

In Figure 7, we show an estimate of the liquidity premium on nominal bonds from 2004 to 2014. 

Specifically, following these authors, our estimate of the nominal liquidity premium is the yield 

on 5-year TIPS, plus the yield on a 5-year inflation swap, minus the yield on a 5-year nominal 

Treasury note. Since an investor can generate the exact same financial cash flows by buying a 5-

year nominal Treasury or by buying a 5-year TIPS note and entering into an inflation swap 

(receiving the swap yield and paying realized inflation), this spread should be zero if investors 

derived the same liquidity services from holding nominal and inflation-indexed debt. By 

contrast, this spread will be positive if investors derive greater liquidity services from holding 

nominal debt. As shown in Figure 7, the liquidity premium on nominal Treasuries versus TIPS 

spiked during the financial crisis and has average roughly 35 bps from 2004 to 2014.

35 Specifically, Fleckenstein, Longstaff, and Lustif (2013) show that the price of nominal Treasury bonds exceeds 

the price of a portfolio consisting of a maturity-matched TIPS and an inflation swap that replicates the cash flows on 

the nominal Treasury. This implies that the yields on nominal Treasuries are lower because of a liquidity premium.

September 30, 2014 41

 
Hutchins Center Working Paper #5

Formally, let S be the fraction of debt that is short term and N be the fraction of debt that is long

term and nominal. The remaining 1–S–N of the debt will be long term and inflation-indexed. Let 

θ ≥ 0 be the liquidity premium on long-term nominal debt and γ ≥ 0 be the premium on shortterm debt, both measure relative to long-term TIPS. Extending the logic in GHS, the optimal 

debt portfolio is given by

,

2 2

, ,

11 1 1

21 1

r

rr rr

S

DV R DV R

π

π π

γ θ β

λ λ = + + − − (10a)

,

2 2

, ,

1 11 , 1 1

r

r r

N

DV R DV R

π

ππ ππ

θ γ β

λ λ = + − − (10b)

where Vπ is the variance of inflation, βr,π is the coefficient from a regression of short-term real 

rates on inflation, βπ,r is the coefficient from the reverse regression of inflation on real rates, and 

R2

r,π is the goodness of fit from these regressions.36

To interpret equations (10a) and (10b), note that if γ = θ = 0, the government should not issue 

long-term nominal debt since doing so only raises the variability of the tax burden in real terms. 

This is consistent with Summers (1997), who summarized the rationale for introducing TIPS in 

1997 as: “We were attracted to them by their ability to stabilize debt payments by the 

government.”

Next, if shocks to short-term real rates and inflation are uncorrelated (so βr,π = βπ,r = R2

r,π = 0), 

the optimal short-term share S depends on the premium on short-term debt (γ) and is limited by 

the volatility of short-term real rates (Vr), and the optimal share of long-term nominal debt 

depends on the premium on nominal debt (θ) and is limited by the volatility of inflation (Vπ). 

Finally, in the plausible case where inflation and real rates are positively correlated, equations 

(10a) and (10b) capture the complementarity of short and nominal debt from a fiscal risk 

perspective. For instance, the tendency to issue short and nominal debt is largest when the R2 

from a regression of real rates on inflation is high. In this case, short-term debt is a good hedge 

for nominal debt and vice versa, so the government can be quite aggressive in catering to the 

special liquidity demands for short-term debt and long-term nominal debt without incurring 

significant tax-smoothing costs.

We have assumed that government debt managers take the inflation process as given. While this 

strikes us as an accurate description of the situation today and in most of the post-war era, this 

may not be true in situations where the debt burden becomes extreme. By relying on nominal 

debt, governments may be able to implement ex post state-contingency by engineering a large 

inflation following the accumulation of significant fiscal deficits, and the government may be 

able to smooth the real tax burden over time (Stokey and Lucas 1983). Of course, this form of ex 

post state-contingency comes at a significant cost: economists typically think that a large,

36 Equations (10a) and (10b) follow from the observation that with, an unknown future inflation of π, we have 

(λ/2)Var[τ] = (λ/2)D2

[Vr(S – S0)

2 + VπN2 – 2(S – S0)NCπ,r] where Vπ = Var[π] and Cπ,r = Cov[π,r].

September 30, 2014 42

 
Hutchins Center Working Paper #5

unexpected surge in inflation is costly. Nonetheless, this important safety valve may make it 

desirable to rely on long-term nominal debt as opposed to inflation-indexed debt. Looking across 

history, Reinhart and Sbrancia (2011) and Piketty (2013) describe how the accumulation of 

massive government deficits during major wars has often been followed by inflationary episodes 

that have significantly reduced the debt burden in real terms.37 Relatedly, Ferguson, Schaab, and 

Schularick (2014) suggest that periods of central bank balance sheet growth have been undone 

mostly via inflation rather than nominal declines.

B. Catering to other liquidity premia

B.1 On-the-run Treasuries

“On-the-run” Treasuries typically embed a liquidity premium relatively to “off-the-run” issues 

with nearly identical cash flows (Warga 1992; Krishnamurthy 2002). As explained in Vayanos 

and Weill (2008), such a liquidity premium arises due to thick-market externalities that make onthe-run securities especially useful from a risk-management and hedging perspective. Debtbuyback operations, such as those undertaken from 2000 to 2001, can be understood as a case 

where issuing securities with a greater liquidity premium imposes little if any additional fiscal 

risk for the government. Specifically, if there is a special liquidity premium on “on-the-run” 

Treasury securities (e.g., the on-the-run 30-year bond), then the government can engage in a 

form of liquidity creation that entails little, if any, fiscal risk by issuing 30-year bonds that

command a large convenience premium and repurchasing these bonds when they become 29-

year bonds with a much smaller convenience premium (Garbade and Rutherford 2007). 

B.2 Market infrastructure

Our trade-off framework is also useful for thinking about an often-mentioned objective of 

Treasury debt management: promoting the infrastructure and broader efficiency of U.S. capital 

markets. In particular, it may be useful to investors in other fixed-income assets—including 

corporate bonds, municipal bonds, mortgage-backed securities, and asset-backed securities—to 

have liquid benchmark Treasury securities with maturities of 2, 5, 10, and 30 years. Such

transparent benchmarks for the risk-free rate may facilitate new issue pricing in these other 

markets and may also be useful for hedging (Fleming 2000). The desire to maintain liquid 

benchmark Treasury issues became an increasing concern in the late 1990s when the government 

ran a series of large fiscal surpluses and was expected to significantly pay down the debt over the 

time. Indeed, one of the major rationales for the Treasury’s 2000–2001 buyback operations was 

to maintain large 5, 10, and 30-year on-the-run benchmark issues in an era of declining overall 

37 This regularity is linked to the fiscal theory of the price level (Leeper 1991; Sims 1994; Woodford 1995; 

Cochrane 2001). This theory says that if a government has an unsustainable fiscal policy, such that it will not be able 

to repay its debts out of future primary surpluses, then it will choose to inflate away the debt. Thus, the current 

nominal price level is pinned down by the current level of nominal government debt and the expected value of future 

real primary surpluses. In this way, fiscal discipline is a critical necessary condition for price stability.

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Hutchins Center Working Paper #5

debt supply (Sachs 1999, Fleming 2000). Indeed, several sovereigns, including Chile, have opted 

to maintain a liquid benchmark yield curve even when total debt was near zero.38

Promoting financial market infrastructure by issuing liquid benchmark securities can be viewed 

as a kind of nonpecuniary service generated by government debt. However, some of the

“benchmark” value of Treasuries has a public good character, since it is nonrivalrous and 

nonexcludable, and unlike the case of other liquidity services—which are rivalrous and 

excludable—this value is unlike to be fully captured in the market price.

V. THE OPTIMAL DIVISION OF LABOR BETWEEN TREASURY AND 

FED

Given the target structure for the consolidated government debt, how should this be 

operationalized by the Fed and Treasury? And how should decision-making authority shift—if at 

all—between the Treasury and the Fed as economic conditions change?

A. Optimal debt maturity and the monetary policy cycle

In Sections III and IV we described a series of tradeoffs that the consolidated government must 

make to determine the maturity structure of the debt. For simplicity, our discussion treated these 

tradeoffs as static in nature. However, if the tradeoffs shift over time—leading to a time-varying 

optimal debt structure—who should be in charge? For instance, how should the government 

respond if heightened concerns about fiscal risk suggest a longer average maturity at the same 

time that a desire to bolster aggregate demand suggests a shorter average maturity? The 

consolidated debt maturity generated by independent Treasury and Fed action may differ 

substantially from the maturity structure that would result from a coordinated policy. Under the 

current arrangement, neither the Federal Reserve nor the Treasury is caused to view debt 

management on the basis of the overall national interest. 

Table 4 describes the current division of labor between the Treasury and the Fed. Over the past 

30 years, the two traditional objectives of debt management—achieving low-cost financing and 

minimizing fiscal risk—have been handled by Treasury. The two nontraditional objectives of 

modern debt management include managing aggregate demand and promoting financial stability. 

The former has been the exclusive domain of the Fed, while the latter has involved cooperation 

between Fed and Treasury, with the Fed taking a lead in bank regulation.39

38 Since 2003, the Chilean government has regularly issued domestic bonds despite being in a net creditor position. 

The stated aim of these issuances is to enhance bond market liquidity in Chile. 39 For example, see the joint statement by the Federal Reserve and Treasury, “The Role of the Federal Reserve in 

Preserving Financial and Monetary Stability: Joint Statement by the Department of the Treasury and the Federal 

Reserve,” March 2009.

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Table 4

Debt Management over the Monetary Policy Cycle

The four columns of the table list the four objectives of debt management: Achieve the lost cost financing, managing 

fiscal risk, managing aggregate demand, and promoting financial stability. For each objective, the table describes 

which agency is historically charged with the objective, the main policy instrument used to manage the objective, 

and the normal implication for debt maturity. The bottom rows consider two scenarios, one expansionary, and one 

contractionary, and the implications for debt management.

Traditional Policy Objectives Nontraditional Policy 

Objectives

Achieve Lowest 

Cost Financing 

Managing

Fiscal Risk

Managing 

Aggregate 

Demand

Promoting 

Financial 

Stability

Weight on 

Objective

?? ?? ?? ??

Agency 

Historically 

Charged with 

Objective

Treasury Department Treasury 

Department

Federal Reserve Federal Reserve

Key Market 

Friction(s)

Investors derive 

money-like 

services from 

holding shortterm debt

Long-term bond 

market partially 

segmented from 

other markets

Convex costs of 

taxation, budget 

volatility costs, 

run-like 

problems 

Long-term bond 

market partially 

segmented from 

other markets

Excessive 

maturity 

transformation 

by private 

intermediaries

Main Policy 

Instrument

Fraction of debt 

that is very short 

term 

Weighted average 

duration of debt

Weighted 

average duration 

of debt

Weighted 

average duration 

of debt

Fraction of debt 

that is very 

short term

Normal 

Implication for 

Debt Maturity

Issue more debt 

that is very short 

term 

Target a shorter 

average duration 

of debt

Target a longer 

average duration 

of debt

Target a shorter 

average duration 

of debt

Issue more debt 

that is very 

short term

Implications of 

Contractionary 

Monetary Policy 

that Raises 

Short-Term 

Nominal Rates

→ Rise in 

premium on 

money-like 

assets

→ Increase 

amount of very 

short-term debt

→ None, 

assuming 

government 

executes a 

“barbell” 

strategy that 

holds average 

duration constant

→ None, 

assuming 

government 

executes a 

“barbell” 

strategy that 

holds average 

duration constant

→ Rise in 

premium on 

money-like 

assets

→ Increase 

amount of very 

short-term debt

Implications of 

Recession Where 

Deficits Rise and 

ZLB is Reached

 ~ ~ → Extend 

average duration 

since fiscal risk 

looms large

→ Shorten 

average duration 

to bolster 

aggregate 

demand

 ~

Objectives and 

Tactics Conflicts Driven by Monetary Policy

September 30, 2014 45
Hutchins Center Working Paper #5

To tackle the question of who should be assigned responsibility over debt management (and 

whether this assignment should change with economic circumstances), we start by describing 

more precisely the circumstances in which debt management objectives, as they are currently 

interpreted by the Treasury, conflict with the traditional output-inflation tradeoff objectives of 

the central bank, and how easily this conflict can be overcome. 

A.1 Conflict between the Fed and Treasury due to variation in liquidity premia

Consider the stylized description of the monetary policy objectives as given by the Taylor rule

(Taylor 1993), in which the central bank raises interest rates when inflation is above target, and 

lowers interest rates when output is below potential. Further, suppose that the central bank uses 

the short-term interest rate as its only policy instrument. How might the optimal maturity 

structure of the consolidated debt be expected to vary over the monetary policy cycle, and how 

might this interact with the central bank’s traditional objectives of promoting both full

employment and stable prices? 

Consider the case in which the central bank raises interest rates to reign-in aggregate demand to 

head off an incipient rise in inflation. With higher short-term rates, the opportunity cost of 

holding paper money and non-interest-bearing deposits increases, and this increases demand for 

money-like short-term debt such as Treasury bills (Nagel 2014). If the Treasury places weight on 

issuing “cheap” money-like securities to minimize the cost of the debt, the government should 

partially accommodate this greater demand by issuing more short-term T-bills. This motive may 

be further enhanced if the Treasury seeks to lean against the possibility that elevated demand for 

money-like debt may lead to excessive private liquidity transformation—i.e., to avoid a surge in 

short-term debt issuance by financial intermediaries seeking to capture the heightened liquidity 

premium. 

In this case, the conflict between the Fed and the Treasury arises because the Treasury’s effort to 

shorten its debt results in unintended consequences from aggregate demand. As argued earlier, 

shortening the debt might reduce the duration-weighted supply of debt held by the public, and 

thereby depresses the term premium component at long-term rates at precisely the same moment 

when the central bank is trying to tighten monetary policy.40

Is there a way out in which both Treasury and central bank objectives could be accomplished 

without explicit coordination on debt management? In the case described above, this could be 

40 This assumes that expanding the supply of very short-term bills forces the Treasury to lower the average duration 

of the debt. However, at noted by GHS, one may be able expand the supply of short-term bills while holding average 

duration or roughly constant. For instance, to respond to the heightened demand for very short-term debt, the 

Treasury might increase its issuance of 1- and 3-month bills and reduce its issuance of 6-month and 1-year bills. At 

the same time, the Treasury could expand its issuance of 2-year notes in order to hold the average duration constant. 

In this way, the government might be able to respond to the heightened demand for short-term money-like debt 

without depressing the term-premium component of long-term yields.

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Hutchins Center Working Paper #5

accomplished by the central bank raising the short rate by more than it might otherwise have 

done, absent the Treasury’s debt management response. Through this form of “sterilization”—

although a strict second-best to joint decision on debt management—the central bank can undo 

aggregate demand consequences of debt management.

The opposite case—in which the central bank lowers rates while the Treasury lengthens debt 

maturity—poses more difficulty. If nominal interest rates are positive, then the central bank can 

sterilize a rise in the average maturity by lowering rates. However, if interest rates are at or near 

the zero lower bound, debt management limits the central bank’s ability to pursue its traditional 

dual mandate. 

A.2 Fed and Treasury conflict due to changes in outstanding government debt

A second reason why optimal debt maturity may vary over the monetary policy cycle has to do 

with fiscal risk. When the debt rises as a percentage of GDP, the Treasury will prudently want to 

extend the average maturity of the debt to reduce refinancing risk. In ordinary circumstances, the 

debt-to-GDP ratio evolves slowly, reflecting the gradual accumulation of deficits or surpluses 

over time. And thus, during ordinary circumstances, we wouldn’t expect debt-to-GDP ratio—and 

thus the optimal maturity structure of the debt—to be tightly linked with monetary policy 

objectives, which vary at a business cycle frequency. However, things are different when the 

economy enters a severe downturn, such as what the U.S. experienced in 2009. In this case, 

increased fiscal expenditures result in a rapidly growing debt stock, leading the Treasury to 

reevaluate the optimal maturity structure of its debt. At the same time, the central bank would 

like to aggressively use its conventional policy instrument to stimulate aggregate demand. 

As long- as short-term interest rates are above zero, the central bank can in principle offset the 

impact of rising Treasury debt maturity through further reductions in the short-term rate. But 

sterilization of this sort is impossible once interest rates reach the zero lower bound. At this 

point, unless there is coordination between the Treasury and the Fed, it is as if the Fed has 

partially ceded stabilization policy to the Treasury.

A counterargument to this is that the Fed can always use its own balance sheet policies—

effectively debt management—to undo whatever actions Treasury takes. For instance, if the Fed 

wants to reduce the supply of 10-year equivalents by $3 trillion to depress long-term rates and 

the Treasury’s precautionary maturity extension raises the supply by $1 trillion, the Fed can 

simply perform an additional $1 trillion of QE to undo the Treasury’s maturity extension. In 

other words, if the Fed is always the last mover, and the Fed has access to the same set of policy 

tools as the Treasury, it can always undo whatever the Treasury does. 

Clearly, such a “solution” is problematic on many fronts. First, it puts all of the weight on the 

Fed’s objective function, and thus ignores the Treasury’s fiscal motivation for increasing 

maturity in the first place. Second, it is a roundabout way of achieving the central bank’s 

objective. If the central bank is free to choose the government’s consolidated debt structure, then 

September 30, 2014 47
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the Treasury should simply hand over the keys. Third, the Fed may already be constrained in its 

QE operations by public perceptions about the size of its balance sheet, and in this case it makes 

no sense to further constrain the policy by forcing it to additionally undo Treasury action.41

B. The optimal division of labor

To sum up, debt management may conflict with monetary policy objectives for at least two 

reasons. First, when the government alters the share of its debt that is short term to react to shifts 

in money demand, this may have implications for aggregate demand that differ from the Fed’s 

objectives under its traditional dual mandate. Second, the set of circumstances in which fiscal 

risk looms large—leading the Treasury to lengthen the average maturity of the debt—are also 

circumstances in which the central bank may be up against the zero lower bound on conventional 

monetary policy.

Where does that leave us? In the case of positive short-term interest rates, we favor an 

arrangement under which the central bank can manage the inflation output tradeoff as it sees fit,

and can sterilize the aggregate demand impact of any policies that change the maturity 

composition of the debt using the short-term interest rate. Debt policy can be made by the 

Treasury on grounds of optimal public finance broadly understood to include financing the 

government at least cost over time, managing fiscal risk, and promoting financial stability. But, 

because of the importance of debt management for the functioning of financial markets and 

because of its relation to financial stability, the Federal Reserve should have a more significant 

advisory role than it does currently. 

If the central bank is able to sterilize the effects of debt management on aggregate demand using 

the short-term interest rate, then is there any reason for the Fed and Treasury to cooperate? 

Suppose that, following Treasury’s decision on the maturity structure of the debt, the Fed can 

precisely fine tune the short-term interest rate to achieve a desired level of aggregate demand. 

Absent cooperation on debt management, policy outcomes will be at second best, because they 

necessarily reflect the central bank’s weights on the output-inflation tradeoff over Treasury debt 

management objectives. More broadly, using two instruments sequentially to achieve four policy 

goals is inferior to choosing the two instruments simultaneously. This conclusion is further 

reinforced when we recognize that policy instruments map to policy outcomes with long and 

variable lags and with considerable uncertainty.

How do we see cooperation between the Fed and the Treasury occurring in practice? A natural 

solution would be for the Fed and the Treasury to annually release a joint statement on the 

strategy for managing the U.S. government’s consolidated debt. This would establish a plan for 

the maturity structure and composition of debt issued by the Treasury, and supported by the 

41 Rudebusch (2009) suggests that the $2 trillion Fed balance sheet in 2009 “only partially offset the funds rate 

shortfall.” Relatedly, Rudolph (2014) argues that the Fed asset purchases would need to reduce long-term rates by 

200 basis points to offset the shortfall implied by a standard Taylor rule. 

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Federal Reserve. The Fed would be given the flexibility to make interim adjustments to debt 

management policy to engage in large-scale outright purchases or sales in response to economic 

or financial developments if such policies were needed to pursue its dual stabilization mandate. 

At the same time, annual coordination of this sort would make it unlikely that the Fed and the 

Treasury would be working at cross purposes for long periods of time. 

At the zero lower bound, this arrangement would cause the Treasury to internalize the Federal 

Reserve’s desire shorten maturity in order to stimulate aggregate demand. Similarly, the Federal 

Reserve would have to recognize the Treasury’s precautionary fiscal motive for lengthening the 

maturity. In such situations a fully coordinated policy that the Treasury and Fed pursue with 

respect to currency intervention should be the norm.

There is also the question about which agency should accommodate shifts in the demand for 

money-like short-term debt that may arise over the business cycle as well as higher-frequency 

demand shifts due to “flight to quality” events. For instance, consider the large increase in 

demand for liquid short-term debt during the 2008–2009 global financial crisis or during the fall 

1998 crisis. Should such a demand shock be accommodated by the Treasury quickly issuing a 

large amount of bills? Or should it be accommodated by the Fed purchasing longer-term 

Treasuries financed either through an increase in interest-bearing reserves or reverse repurchase 

agreements (i.e., via Fed balance sheet expansion) or by selling Treasury-bills (i.e., via an 

Operation Twist)?

Because Treasury bills, reverse repurchase (RRP) agreements with the Fed, and interest-bearing 

reserves are all very close substitutes, in principle either the Fed or the Treasury could take the 

lead in accommodating shifts in the demand for money-like short-term government debt. And 

regardless of whether the Treasury or Fed played the lead role, greater coordination is called for 

on this front since the Treasury and the Fed share responsibilities for promoting the stability of 

the financial system.

On balance, it seems most natural to delegate this role to the Fed due to its operational expertise 

in open market operations and its expertise in communicating with participants in funding 

markets. 42 In a sense, responding to shifts in the demand for money-like short-term debt is 

central banking in the classic sense of elastically supplying a special asset that supplies liquidity

services and impacts financial stability. For instance, by using its RRP capability, the Fed could 

expand and contract the size of SOMA’s holdings of long-term Treasuries backed by reverse 

repo funding in order to target a constant convenience premium on short-term money-like debt, 

which would be accomplished through standard open market operations. Of course, if this 

42 Such high-frequency accommodation would likely pose significant operational challenges for the Treasury. For 

instance, it would be difficult to quickly contract the supply of bills in response to a change in market conditions 

(i.e., it would need to issue long-term notes or bonds to repurchase bills). In contrast, the Fed would simply contract 

the size of the SOMA by open-market sales of long-term Treasuries, unwinding the associated RRP funding. It can 

also be argued that the Fed has a comparative advantage at managing any “rollover” risk associated with short-term 

debt: there cannot be a destabilizing “run” on the monetary base, but there could be a run on the T-bill market. 

September 30, 2014 49

 
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liquidity provision and financial stability role were delegated to the Federal Reserve it would 

likely need to maintain a balance sheet that was larger than its pre-crisis balance sheet.43

VI. CONCLUSION

Motivated by the blurring of functions between the Federal Reserve and Treasury following the 

financial crisis, this paper reconsiders the problem of the optimal management of the public debt. 

Our primary contributions are to quantify the extent to which the Fed and Treasury have been 

working at cross purposes and to present a framework in which traditional debt management 

objectives—financing the government at the lowest cost over time and insulating the budget 

from refinancing risk—can be considered in conjunction with the nontraditional objectives of the 

QE era: managing aggregate demand and promoting financial stability.

We emphasize three findings. First, we suggest that the case for shorter-term debt is stronger and 

the case for maturity extension is weaker than is generally thought. Specifically, the additional 

budget volatility caused by shifting more debt to short-term is modest, particularly when 

compared with the volatility of primary deficits. Second, a primary motive for issuing more

short-term debt—capturing the extra liquidity premium on short-term bills—varies substantially 

over time. At the time of writing, for example, the liquidity premium on short-term bills stands at 

all-time lows, reducing the incentive to go short-term right now. This also means that, even 

absent aggregate demand implications, debt management cannot be static. Third, because debt 

management is time-varying and has implications for aggregate demand, it puts the Treasury into 

conflict with the Federal Reserve, even if the Federal Reserve is not explicitly using debt 

management as a policy tool. However, we suggest how improved policy coordination could 

substantially reduce this conflict.

43 Gagnon and Sack (2014) and Cochrane (2014) also argue in favor of maintaining a permanently larger Fed 

balance sheet in the new era with interest-bearing Fed liabilities.

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