Congress has assigned to Treasury the responsibility of borrowing the funds necessary to finance the gap between cash-in and cash-out, subject to a statutory limit. Treasury’s primary debt management goal is to finance the government’s borrowing needs at the lowest cost over time. Issuing debt predictably through regularly scheduled auctions lowers borrowing costs because investors and dealers value liquidity and certainty of supply. Treasury responds to increases in borrowing needs in a traditional manner, by first increasing the issuance size of existing securities; then, increasing the frequency of issuances; and finally, introducing new securities to its auction calendar as necessary. Treasury normally auctions nominal marketable securities that range in maturity from 4 weeks to 30 years and sells them at auction on a pre- announced schedule. Treasury also issues cash management bills that are not part of the regular schedule to meet immediate cash needs. Treasury securities are widely viewed as the premium risk-free asset and are actively used by investors, traders, and foreign central banks for hedging, liquidity, and reserve purposes. The outstanding mix of U.S. Treasury securities can have a significant influence on the federal government’s interest payments. Longer term securities typically carry higher interest rates (which translate to increased cost to the government), primarily due to concerns about future inflation. However, these longer term securities offer the government the certainty of fixing the interest payments over a longer period and reduce the amount of debt that Treasury needs to refinance in the short term. In contrast, shorter term securities generally carry lower interest rates but add volatility to the government’s interest costs and require Treasury to conduct more frequent auctions to refinance maturing debt. During the 1980s and 1990s, a number of countries introduced inflation- indexed securities to their debt offerings, including the United Kingdom, France, and the United States. In January 1997, Treasury introduced its own inflation-indexed securities, TIPS, as part of its debt program. At the time, Treasury’s stated objectives for introducing TIPS were both to raise the national savings rate and to reduce the federal government’s cost of borrowing. TIPS offer inflation protection to investors who are willing to pay a premium for this protection in the form of a lower interest rate. In a functioning TIPS market, the difference between the interest rate on nominal Treasury securities and the interest rate on TIPS should approximately equal the expected inflation rate. Treasury currently issues 5-, 10-, and 20-year TIPS. In the past, Treasury issued 30-year TIPS, but discontinued them in 2001. See appendix I for additional details on the structure of TIPS. To identify the debt management challenges associated with Treasury’s increased borrowing, we analyzed the scale, timing, term to maturity, and composition of Treasury’s borrowing since the start of the economic recession, using data and information obtained from the Department of the Treasury and the Federal Reserve. We also interviewed market experts, Treasury, and Federal Reserve staff and officials. To examine what role TIPS should play in Treasury’s debt portfolio and the potential for the TIPS program to help address Treasury’s debt management challenges, we conducted literature reviews on the costs and benefits of inflation-indexed securities and examined research by Federal Reserve economists, market experts, academic sources, and the Department of the Treasury, including an internal review of the TIPS program done by the Office of Debt Management (ODM). We also conducted 12 structured interviews in June 2009 with the two largest holders of Treasury securities in each of the following sectors: mutual funds; commercial banks; life insurance companies; property and casualty insurance companies; state and local pension funds; and private pension funds. The major institutional investors we interviewed held at least $351 billion in Treasury securities. Of their Treasury holdings, $99.4 billion were TIPS, which was 19 percent of total outstanding TIPS as of March 31, 2009. These interviews covered the institution’s holdings of Treasury securities, demand for TIPS, changes that could be made to the TIPS program, perceived risks to investors in Treasury markets, and Treasury’s sources for information on demand for Treasury securities. On July 1, 2009, we briefed Treasury’s ODM on the findings from the structured interviews, which are discussed and expanded upon in this report. Where possible and appropriate, we corroborated the results of our data analyses and interviews with other sources. On the basis of our assessment we believe that the data are reliable for the purposes of our review. We conducted our review from June 2009 through August 2009 in accordance with generally accepted government auditing standards. Those standards require that we plan and perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our findings and conclusions based on our audit objectives. We believe that the evidence obtained provides a reasonable basis for our findings and conclusions based on our audit objectives. Treasury faces two near-term challenges in managing the growing government debt: the rise in total outstanding debt and the shortening of the average maturity of the debt profile. Treasury’s total outstanding debt increased by $2.3 trillion (25 percent increase in federal debt) since the onset of the economic recession in December 2007. In actions Treasury described as in accordance with normal operating procedures, Treasury increased short-term borrowing to address its massive and immediate borrowing needs. As a result, the average maturity of Treasury’s debt decreased as the percentage of marketable debt maturing within 1 year increased from 35.6 percent to 41.1 percent between September 2007 and June 2009. At the end of June 2009, Treasury’s outstanding marketable securities stood at $6.6 trillion, an increase of almost $2.1 trillion from December 2007. The largest increase in outstanding marketable Treasury securities was in short-term debt. Treasury bill and cash management bill issuance increased by a combined $1 trillion between December 2007 and June 2009. The amount of Treasury notes issued also increased significantly over this period, adding $929.3 billion to the amount of notes outstanding. Almost half of the increase was comprised of shorter-term notes (with 2-year and 5-year maturities). The monthly issuance of 2-year notes alone has almost doubled in the last 2 years. Figure 1 shows the relative size of the increases in different categories of securities. The smallest increase was in TIPS which increased by $60.6 billion. Treasury has raised significant amounts of cash since the onset of the economic recession in December 2007 largely by adhering to its regular and predictable debt issuance schedule, which is meant to ensure the lowest borrowing costs over time. However, Treasury has also turned to issuing cash management bills, which are announced shortly before auction to fulfill Treasury’s immediate cash needs. After the financial market crisis hit in fall of 2008, Treasury raised an unprecedented $1.1 trillion in under 18 weeks largely by issuing cash management bills. Treasury was able to finance such an amount due in part to outsized demand among global investors for a safe and liquid financial instrument in the midst of the contraction in global economic activity. As shown in figure 2, 78 percent (or about $5.1 trillion) of the outstanding marketable Treasuries mature by 2015 and will need to be rolled over (or refinanced)—potentially at higher interest rates. Because short-term rates have been reduced sharply by the decision of the Federal Reserve to set its federal funds target near zero, Treasury’s borrowing costs decreased even though debt levels increased. (See figure 3.) However, projections from both the Congressional Budget Office (CBO) and Office of Management and Budget (OMB) assume higher interest rates and higher interest payments. CBO’s analysis of the President’s Budgetary Proposals for Fiscal Year 2010 assumed that interest rates on 91-day Treasury bills would increase from 0.3 percent in 2009 to 4.7 percent in 2015 and that interest on 10-year Treasury notes would increase from 2.9 percent to 5.4 percent over the same period. CBO’s analysis of the President’s Budgetary Proposals for Fiscal Year 2010 shows—absent changes in policy—interest payments on federal debt more than tripling—to almost $800 billion—by 2019. (See figure 3.) See Congressional Budget Office, An Analysis of the President’s Budgetary Proposals for Fiscal Year 2010 (Washington, D.C.: June 2009). gradually transition the portfolio into longer term debt. They also told us that, given the need to be flexible operationally, Treasury’s debt management horizon is shorter than the horizon used by CBO and OMB in budget projections and that they are confident about their ability to finance the projected budget deficits for 2010 and 2011. As noted, the federal government’s policy response to the financial market crisis and the economic recession created a significant increase in both debt and debt management challenges. These will not recede when stability returns to financial markets and economic growth resumes. CBO projects that, absent changes in current policy, the debt held by the public will double in 5 years (from 2008 to 2013) and almost triple in 11 years (from 2008 to 2019). (See figure 4.) CBO projects that debt held by the public will increase from 41 percent of gross domestic product (GDP) in fiscal year 2008 to 71 percent by the end of fiscal year 2013. The actions that Treasury has taken to increase borrowing in response to the economic recession and financial market crisis take place within the context of the already serious longer term fiscal condition of the federal government. While the administration and Congress have been understandably focused on addressing problems with financial markets and responding to the economic recession, the government will need to apply the same level of intensity to the nation’s long-term fiscal challenge. Both our long-term simulations and CBO’s show growing deficits and debt, underscoring that the long-term fiscal outlook is unsustainable.