To view or print the PDF content on this page, download the free AdobeAcrobatReader.
Dear Mr. Secretary:
Since the Committee's last meeting in August, economic growth has remained firm in spite of the material impact of hurricanes Katrina and Rita, which had a devastating impact along the coast of the Gulf of Mexico. While 2005 GDP growth will be above its long-term trend of 3.2%, it seems likely that growth will soften in the near term due to record energy costs, which have slowed personal spending growth. Investment spending continues to grow strongly, supported by robust home sales and investment in capital equipment. Though capital equipment spending may have moderated at the end of Q3 due to transportation disruptions from the hurricanes and a strike at Boeing, demand remains high, as evidenced by a record level of unfulfilled orders for durable goods.
The hurricanes significantly affected employment, as September non-farm payrolls shrank by 35,000, whereas payroll growth averaged 221,000 in the three months preceding the storm. Accompanying job losses from the hurricanes, the unemployment rate rose to 5.1% in September from a cyclical low of 4.9% in August. In addition, the insured unemployment rate rose to 2.3% in October.
Energy prices have begun to decline from record levels following the hurricanes. However, the moderation did not occur soon enough to prevent headline CPI inflation from reaching 4.7% in September, the highest since 1991. Price increases outside of food and energy have been modest. The core CPI deflator rose at a 1.5% annualized pace in Q3, lower than the 2.0% annualized pace of both Q2 and the 1.7% annualized pace of a year ago. The core PCE deflator increased at a 1.3% annualized pace in Q3, lowering its year-over-year (Y/Y) change in Q3 to 1.9%. The pass-through of higher energy prices and a pickup in unit labor costs raise the risk that increases in core inflation may be ahead. However, with energy prices slipping from record levels, headline inflation should soon return to less elevated observations. Foreign demand looks to have little impact on inflation, as the trade-weighted dollar is virtually flat from a year ago.
Yields on U.S. Treasury securities have risen in anticipation of continued Fed tightening. Rates have backed up across the entire curve, reflecting a combination of higher estimates of the sustainable level of overnight rates and emerging uncertainties about the path of inflation. This process has slowed the intense pace of curve flattening evident throughout the tightening cycle. Forward markets are expecting that the funds rate will peak next year, leveling off in the 4.5% area.
The level of Q3 reported operating earnings is forecasted to be somewhat lower than Q2, although the Y/Y growth rate will increase due to a favorable comparison. Q3 operating earnings look to be 0.4% lower than Q2, but 14.7% higher than a year ago. As of Friday, October 28, 2005, 69% (market capitalization) of the S&P 500 had reported earnings; 78% had met or beaten expectations, while 22% had failed to meet expectations. Operating earnings have thus far surprised to the upside by 1.8%. Continued strength in oil prices supported Energy Sector earnings, with lower earnings evident in the Consumer Discretionary and Materials sectors. Insurance losses from the hurricanes led to lower Financial Sector earnings.
Cyclical forces narrowed the recently completed fiscal year's Federal budget shortfall to $319 billion, or 2.6% of GDP. The expansion should continue to lift tax receipts, albeit at a more moderate pace, in the year ahead. However, public spending may rise by a similar amount given spending blueprints and hurricane-related appropriations.
Against this economic and financial backdrop, Treasury representatives presented a series of charts summarizing the near-term outlook and associated financing requirements. Charts depicting daily operating cash balances, drivers of financing needs, projected net borrowing with hypothetical auction sizes, and distributions of the outstanding debt portfolio were shown. Highlights included projections for a stabilization of average maturity of total outstandings at 55 months due to reintroduction of the 30-year bond, and total outstandings under 3 years continuing to decline with bill pay down. It was observed that the current coupon pattern and issuance amounts will leave Treasury with ample flexibility to handle significant variance to current budgetary forecasts.
In the first section of the charge, Treasury asked the Committee to discuss several prospective changes to its issuance calendar. Specifically, Treasury asked for comments on whether or not it should cluster supply and whether there are advantages to moving 5-year note auctions to month-end during the quarters when it issues 30-year bonds. Treasury also asked whether staggered announcement dates are preferable or not, and lastly, whether the 30-year auction cycle would impact 20-year TIPS auctions. To the first part of the charge, members observed that the amount of duration risk sold at the clustered auction periods would not be large relative to historical volumes and market liquidity. Members generally felt that clustering of auctions would also be advantageous for market attention purposes. Most members felt that regular month-end 5-year note auctions would be preferable to other alternatives and that single announcements of month-end auctions were preferable to staggered announcements. Finally, given the unique and different characteristics of 20-year TIPS and 30-year bonds, members opined that there would be no impact on 20-year TIPS auctions from the February/August 30-year bond issuance cycle.
In the second section of the charge, Treasury asked for the Committee's views as to when and under what circumstances the deployment of an emergency securities lending facility should be offered to the market, a topic previously discussed in August. Treasury asked the Committee to suggest a construct that was only economically attractive during periods of protracted fails as well as to opine generally about the merits of the facility being considered.
Treasury had expressed concern in prior meetings that in periods of market stress, particularly those times when counterparty credit risk is elevated, a protracted fail could hamper transactional liquidity in Treasury obligations, causing borrowing costs to rise. Additionally, Treasury noted that in low-rate environments, chronic fails can persist for very long periods of time as the cost of failing to deliver securities is nominally low.
The Committee engaged in a wide-ranging discussion of the merits and design of such a facility. Most members felt that a facility was clearly a good idea if it lowered the cost of borrowing demonstrably and encouraged Treasury to develop analysis whereby it could test those perceived benefits. Quantifying the benefits of a lending facility through lower cost of borrowing was considered the most important benchmark to determine the merits of the facility. Members then discussed conditional measures to test the merits of the facility if the borrowing cost benefit was clearly demonstrable. Most members felt that the introduction of a facility would be a good idea if it served to limit the potential of a debilitating credit event or other catastrophic occurrence. As such they argued, that establishing a penalty borrowing rate well below the zero bound would allow market participants to fulfill contracts to sell specific securities assuaging counterparty concerns. However, many members counseled Treasury not to link the implementation of the proposed facility to the enforcement of buy-in rules citing a lack of clarity of precedence or understanding of how consistent procedure would be applied. Members strongly encouraged Treasury not to inadvertently tinker with a well functioning market by imposing additional regulatory burdens. They asserted that markets have thrived with less regulatory interference and that Treasury could endanger its enviable borrowing costs through increased regulatory imposition. Some felt that a linkage between buy-in rules and a lending facility would be detrimental to the efficient functioning of the markets, and would promote speculative activity not intended at the outset. Members encouraged Treasury to emphasize simplicity and to clearly define the circumstances under which the facility would be implemented.
At the conclusion of the discussion, members generally felt that adding a lending facility to the list of protracted fail mitigants, namely suasion, large reporting requirements and tap auctions could serve as a valuable policy tool on an infrequent basis. However, members urged Treasury to take great care not to inadvertently disrupt a well functioning marketplace.
In the last section of the charge, the Committee considered the composition of marketable financing for the October-December quarter to refund $38.7 billion of privately held notes and bonds maturing on November 15, 2005 , as well as the composition of Treasury marketable financing for the remainder of the October-December quarter and the January-March 2006 quarter. To refund $38.7 billion of privately held notes and bonds maturing November 15, 2005 , the Committee recommended a $18 billion 3-year note maturing November 15, 2008 , a $13 billion 5-year note due November 15, 2010 , and a $13 billion 10-year note due November 15, 2015 . For the remainder of the quarter, the Committee recommended a $20 billion 2-year note issued in November, a $20 billion 2-year note issued in December, a $13 billion 5-year note issued in December and a $8 billion reopening of the 10-year note in December. The Committee also recommended a $12 billion 12-day cash management bill issued November 18, 2005 and maturing November 30, 2005 and a $25 billion 9-day cash management bill issued December 6, 2005 and maturing on December 15, 2005. For the January-March quarter, the Committee recommended financing as contained in the attached table. Relevant features include three $20 billion 2-year notes, a $18 billion 3-year note, three $13 billion 5-year notes, a $13 billion 10-year note in February, a $15 billion 30-year bond, followed by a $8 billion reopening of the 10-year note in March. The Committee further recommended a $8 billion 10-year TIPS in January and a $8 billion reopening of the 20-year TIPS.
Ian G. Banwell
Thomas G. Maheras