william c dudley : the case for tips – an examination of the costs and benefits remarks by mr william c dudley, president and chief executive officer of the federal reserve bank of new york, at the federal reserve bank of new york inflation - indexed securities and inflation risk management conference, new york, 10 february 2009. * * * welcome to the new york fed and to this timely conference on inflation - indexed securities and inflation risk management. before discussing " the case for tips ", i would like to thank conference organizers, participants, panelists and supporting bank staff for planning and putting together today's event. in particular, i wanted to thank john campbell for his contribution to making today's conference a reality and i expect that his involvement will heighten attention to this subject and stimulate additional research from the academic community on the topics we discuss here. over the past year, treasury has been evaluating the costs and benefits of the tips program. some research studies on this topic have concluded that the incremental financing costs associated with the tips program have been substantial ; leading some to conclude that the costs may outweigh the benefits. today ’ s program, which includes a panel discussion on the welfare benefits of inflation - protected securities, should help to broaden our knowledge on this topic. as the title of my speech suggests, today i am going to lay out the reasons why i, along with my colleagues jennifer roush and michelle steinberg ezer, believe that the benefits of the tips program exceed the costs of the program. before saying anything more, let me emphasize that the views i express today are my own and those of my co - authors and, therefore, may not represent the views of my colleagues on the federal open market committee. also, let me note that jennifer and michelle are the main authors of this paper. i have ridden along on their coattails. my main contribution was to slow down completion as i had to fit in my very modest contributions around the unfolding financial crisis! finally, you may be wondering why this is my first speech since i have become president – an odd subject to choose, perhaps, given the ongoing financial crisis? the answer is a simple one, our paper and this conference have been in train for a long time. it is just a coincidence that the conference and my becoming president of the new york fed have happened to arrive at about the same time. the logic of issuing inflation - protected securities is straightforward. wouldn ’ t some investors pay a premium – that

they would purchase tips at a price above that implied by their expected payment stream. as such, inflation risk premiums result in lower expected borrowing costs for the government and savings for the tips program compared with nominal issuance. to determine which factor has been historically dominant, we conduct an ex - ante cost analysis : we compare the amount that the treasury received for inflation compensation at auction with an observable measure of the inflation expectations of tips investors that is not contaminated by premiums for inflation risk or liquidity differentials. unfortunately, we don ’ t have a perfect measure of expected inflation. nevertheless, we may be able to get close. we do have estimates of expected inflation from other sources – such as the survey of professional forecasters ( spf ) conducted by the federal reserve bank of philadelphia. if such measures do indeed reflect the inflation expectations of investors, then we can conduct a reasonably accurate ex - ante analysis. tips analysts often talk about a concept they call the breakeven inflation rate. essentially, this is the realized inflation rate that would cause investors to come out the same in terms of total compensation regardless of whether they had bought tips or nominal treasuries. the difference between the auction breakeven inflation rate and the spf forecast yields a measure of the net savings or loss incurred by the treasury that is independent of forecast errors. it is also equal to the net value of the illiquidity and inflation risk premiums associated with each tips. our analysis, which covers tips auctions through april 2008, found that prior to 2004, the breakeven inflation rate was below the spf. this indicates that the illiquidity premiums exceeded the inflation risk premium over this period. however, since 2004, we find that breakeven inflation rates were approximately equal to expected inflation, indicating that investors were roughly indifferent between the benefit of being protected against inflation risk versus the cost in terms of the greater illiquidity of tips relative to onthe - run nominal treasuries. thus, on an ex - ante basis, it appeared that the cost of issuing tips was about equal to the cost of issuing nominal treasuries. to determine the impact of the illiquidity premium and inflation risk premium on these results, we decomposed our ex - ante analysis, comparing the breakeven rate of inflation excluding the illiquidity premium in tips yields 3 to the spf forecast. this comparison yields an in addition