The Fed does not target asset prices, Chairman Greenspan tells us. Again and again, for years and years, he’s told us. Rather, the Fed targets economic outcomes, notably maximum employment and price stability. Putting a slightly finer point on the matter, he says the Fed targets maximum employment consistent with price stability .

This finer point is consistent with holy Fed doctrine that the central bank cannot, in the long run, influence employment (a real variable) and can only influence the price level (a nominal variable). Fed officials religiously espouse that there is no long-run Phillips Curve (or if there is, it is oxymoronically not a curve, since it’s vertical): there is no long-term trade off between inflation and unemployment. Thus, goes the Fed’s epistemology, the Fed not only doesn’t target asset prices, it also doesn’t target unemployment.

In the long run, the Fed argues stringently, the central bank should be held accountable for only that which it has the power to control: the nominal price level and/or changes in the nominal price level — an inflation target consistent with effective price stability. The Fed does not, however, choose to officially and explicitly tell us its inflation target, as doing so would limit the Fed’s flexibility, Mr. Greenspan tells us.

Nice work if you can get it: a license to tinker in real time in things putatively outside your control, and also a license to operate without an explicit performance objective in the long run for the one that you say you can control. It’s a risk management paradigm, Chairman Greenspan argues. It could also be a called a maestro-digm, I suppose.

The figure is a line graph showing the U.S. real yield on Treasuries versus U.S. Treasury Inflation-Protected Securities (TIPS). Real yield is scaled on the vertical axis, and the TIPS yield curve, in maturities ending from 2007 to 2032, is on the horizontal axis. For the line representing today (April 2004), the yield curve begins with an upward slope, from about negative 0.25% for 2007 TIPS to about 1.75% for 2032 TIPS. It steepens at 2012 TIPS, then levels off at 2028 TIPS, and declines slightly out to 2032 TIPS. Two other lines are higher up, and parallel the line representing today. One line represents 2003, and is about 50 to 75 basis points higher, depending on the TIPS year. Another line above it represents 2002, another 50 basis to 75 basis points higher. So, over time the yield curve has shifted downward. 

No, I’m not warming up for a Fed-bashing essay. Honest! In fairness, part of the reason that the Fed (1) preaches transparency while (2) resisting a transparent long-term inflation objective while (3) bobbing and weaving about targeting either asset prices and/or the unemployment rate is that in real time, the Fed necessarily must target both asset prices and unemployment. This is how the Fed works!

The tricky communication challenge for the Fed is to do in real time the only thing that it can do — target unemployment by targeting asset prices! — while maintaining that in the long run, it does not really do these things. Consumers of Fedspeak, much to the Fed’s chagrin, understand that the long run is nothing more than a compendium of short runs.

First, a Necessary Dose of Theory
In real time, Fed officials, even libertarian Chairman Greenspan, acknowledge that the Phillips Curve exists: in real time, there is a trade-off between unemployment and inflation. Indeed, the whole concept of an output gap — the cat’s meow of the Fed’s current patience with maintaining a very accommodative stance — is founded on the existence of a short-term trade-off between unemployment and inflation. And there is only one coefficient between the output gap and the unemployment gap: Okun’s Law, which is the coefficient — estimated variously between 2 and 3 - between the output gap in percent-of-GDP terms and the unemployment gap in percentage-point terms.

In fact, many analysts, most certainly including me, as well as a number of Fed policymakers, infer the output gap from our visceral sense of the unemployment gap, rather than the other way round! To wit, we start with our gut estimate of the "full-employment unemployment" rate, variously called the "natural" rate and the NAIRU (non-accelerating inflation rate of unemployment), and subtract it from the actual unemployment rate to come up with an unemployment gap; then we multiply by 2 ½ and, viola´, we have an output gap estimate.

For example, suppose the NAIRU is 4 ½%  while actual unemployment is 5 ½%: a one-percentage point unemployment gap times a 2 ½ Okun’s Law Ratio gives us a 2 ½ percent-of-GDP output gap. That means, in simple terms, that GDP would have to grow 2 ½ percentage points faster than "potential" GDP growth for a year to reach "full" employment, a journey that could be accomplished without any upward pressure on inflation, and indeed, possibly downward pressure on inflation.

From Theory to Reality
In fact, this example is very close to the Fed’s current perspective: the central bank can, in its own words, remain accommodative for a considerable period and/or be patient in removing its current accommodative stance because:

(1) inflation is in the lower half of the Fed’s implicit inflation target zone, (effective price stability definition of 1-2% for the core PCE deflator), while

(2) unemployment is some one percentage point above the Fed’s implicit 4 ½%-5% NAIRU estimate (with Chairman Greenspan musing that it might be as low as 4%!).

More specifically, on August 12, the FOMC said:

"….the probability, though minor, of an unwelcome fall in inflation exceeds that of a rise in inflation from its already low level. The Committee judges that, on balance, the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future. In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period."

On December 9, the FOMC fine-tuned the rhetoric of the August statement, which had been repeated on September 16 and October 28th, declaring:

" The probability of an unwelcome fall in inflation has diminished in recent months and now appears almost equal to that of a rise in inflation. However, with inflation quite low and resource use slack, the Committee believes that policy accommodation can be maintained for a considerable period."

And then, on January 28, in much more than a fine-tuning of rhetoric, the FOMC said:

"The probability of an unwelcome fall in inflation has diminished in recent months and now appears almost equal to that of a rise in inflation. With inflation quite low and resource use slack, the Committee believes that it can be patient in removing its policy accommodation."

I have zero problems with what the Fed has been doing. The world desperately needs reflation and the Fed is reflating, openly and forcefully, with a falling dollar transmitting the reflationary impulse to the rest of the world. Bravo!

When Good Things Must Come to an End
Even though I agree with what the Fed is doing, I must quibble with the Fed for refusing to be quantitatively transparent about what it is doing and why, choosing instead to speak in platitudes of flexibility. At the moment, this is not a problem. But it will become a problem the moment that the Fed decides the time has come to throttle back on the reflationary process. The "exit" from prudent reflationary policies before they become imprudent will be much more orderly - and much less threatening to the economy’s performance itself - if the Fed answers a few questions before heading for the door.

  • What is the Fed’s inflation target?
  • What is the Fed’s estimate of the full-employment unemployment rate (NAIRU)?
  • What is the Fed’s estimate of the short-term trade-off between inflation and unemployment: how much slack over how much time generates how much "unwelcome" disinflation pressure?
  • What is the Fed’s estimate of equilibrium real short-term interest rate?

Simply put, what I want the Fed to do is spell out its reaction function, commonly known as its Taylor Rule. The Fed, especially Fed Chairman Greenspan, is reluctant to do such spelling. And in one key respect, this reluctance is eminently defensible. The structure of both the economy and the transmission mechanism for monetary policy is constantly evolving. Thus, the Fed’s reaction function - how it responds to real time data in the context of its longer-term goals — must be a living creature, not some static rule.

Accordingly, were the Fed to quantify its reaction function for the public, it would invite upon itself a communication problem, when at some future date, structural change demands a change in the reaction function itself. Put differently, as all parents have learned, ambiguity can sometimes be constructive, so as to avoid having to explain that one has changed one’s mind, even when one has indeed changed one’s mind.

But sometimes ambiguity is not constructive, as all parents have also learned. Ironically, the FOMC made precisely this mistake last August when it introduced the phrase "considerable period" — linking policy to the calendar, rather than unfolding economic conditions. The FOMC’s heart was in the right place, in that the Committee wanted to communicate that the doctrine of pre-emptive tightening was dead, as well it should be, once the promised land of effective price stability has been reached.

But by implicitly referencing the calendar, rather than the Fed’s policy reaction function, the FOMC needlessly created conditions for a rational bubble in asset prices. Yes, I said rational bubble: an invitation for investors to rationally disregard interest rate risk, expanding their use of leverage, until the central bank withdraws the calendar-driven commitment to eschew tightening policy .

Recognizing its mistake of dangling before markets a calendar-linked commitment to remain friendly, the FOMC tightened its rhetoric in December, explicitly linking the "considerable period" phrase to an economic conditions-driven exit strategy: when economic slack was not so slack. The FOMC went even further in January, ditching entirely the "considerable period" phrase, while becoming even more explicit that the "accommodative" 1% Fed funds rate would eventually need to be lifted; but only after the due exercise of appropriate "patience," of course.  

Thus, the Fed remains in a rhetorical asset price targeting cul de sac of its own making: asset prices are higher than can be rationally justified once the Fed normalizes up the Fed funds rate, but rational investors are willing to hold them at those irrational levels, on the thesis that they are rational until the Fed actually signals that the Fed funds rate is about to go up. In less technical terms, the Fed has created a bigger fool game, in which everyone is willing to play the fool, on the thesis that the Fed has to play the role of the last fool, with a duty to warn all the other fools to get out of the levered pool before pulling the plug on it.

In recent weeks, various Fed officials have started the warning process, but to date, such warnings have fallen on liquidity-logged ears. Most significantly, Fed Governor Kohn, who just last week said:

The FOMC stated again last week that it believes it can be patient in removing its policy accommodation. I would note that patience in policy action can take several forms. One form would be to wait before taking any action; another would be a dampened trajectory for the funds rate once tightening begins. A more gradual increase that begins sooner might enable the Federal Reserve to better gauge the financial and economic response to its actions and reduce the odds that a sharp tightening tack would be required at some point to prevent the economy’s overshooting. However, this approach might also run a larger risk of prematurely truncating the expansion - especially if markets interpret the first tightening move as presaging a rapid return to a so-called neutral policy. Undoubtedly, the FOMC will choose a strategy that does not fit neatly into any box, but these considerations will likely play a role in our deliberations.

Some observers argue that the Federal Reserve has already been too patient. They are concerned that continued policy accommodation is distorting interest rates and asset prices and encouraging a build-up of debt, and thereby laying the groundwork for financial and economic instability. Clearly, the low funds rate has held down long-term interest rates and boosted asset prices. These movements are, in fact, some of the key channels through which monetary policy has stimulated demand. Whether prices in some markets have gone beyond what one might have expected from easier monetary policy is unclear. When interest rates increase, prices will undoubtedly adjust to some extent - in some cases simply by rising less rapidly than they would otherwise - and debt-service obligations will move up. Households, businesses, and financial institutions need to be prepared for this adjustment. But I think the hurdle is high - and appropriately so - for a central bank to tighten policy, and in the process damp an expansion of economic activity in the short run, on the suspicion that movements in asset prices and increases in debt threaten economic stability over the longer run.

Bravo, Governor Kohn! It never ceases to thrill my soul to hear a Fed official speak plainly and truthfully. Yes, he acknowledged, "the low funds rate has held down long-term interest rates and boosted asset prices." And he further acknowledged, "These movements are, in fact, some of the key channels through which monetary policy has stimulated demand." Ergo, the Fed has appropriately used its money printing power to (1) peg a super low Fed funds rate as (2) a means to target higher asset prices (for the record, holding down long-term interest rates is the same as holding up long-term bond prices!), so as to (3) stimulate aggregate demand.

Mr. Kohn demurred in offering an opinion as to whether assets prices are in a bubble - rational or irrational - but does conclude by warning investors that, "When interest rates increase, prices will undoubtedly adjust to some extent in some cases simply by rising less rapidly than they would otherwise and debt-service obligations will move up. Households, businesses, and financial institutions need to be prepared for this adjustment." But not too soon too fast, of course, as the prevailing unsustainable array of asset prices is wonderfully stoking aggregate demand, and too much correction in assets prices too soon would risk "prematurely truncating the expansion," Mr. Kohn warned.

He also explicitly recognized that the Fed’s and the markets’ joint exit from prevailing targeted, rational valuation bubbles could be especially troublesome "if markets interpret the first tightening move as presaging a rapid return to a so-called neutral policy."

Paul Simon may have been able to articulate 50 ways to leave your lover, but Fed officials have many fewer ways to let the air out of asset valuation bubbles - notably in interest rate risk and credit risk — created by purposeful reflationary policies. And, unlike the case with the stock market bubble at the end of the 1990s, the Fed can’t just hope for an immaculate correction.

The term structure of interest rates (note and bond prices) is nothing more than a forward curve for the Fed funds rate, plus a risk premium. What the Fed hopes, as Mr. Kohn intoned, is to avoid the market "pricing in" too much tightening, or too much of a risk premium for tightening, too soon. Call it moral hazard interruptus; and call it a most tricky monetary policy maneuver.

What is Neutral?
Regrettably, the prospective exit strategy is made more difficult by the FOMC’s fling with a calendar-driven commitment to remaining "accommodative." The bubble-promoting "considerable period" rhetoric cannot be un-said, even though the Fed no longer says it. Nonetheless, the FOMC still has both time and scope to lubricate the prudent breaking of its prudent promise to pursue reflationary policy. It is time, I submit, for the Fed to reveal its definition of neutral policy, and worry less about market discounting a too-rapid return to neutral policy. In the absence of such information, markets will, at the first hint of tightening, rationally build in a risk premium for the worst-case scenario of what might constitute neutral.

Most important in this regard is the market’s presumption about the Fed’s assumption as to the "equilibrium" real short-term rate. Technically, this term is the constant in the Fed’s reaction function: the real short-term interest rate that would prevail if the economy was in "equilibrium" - inflation at target and no output gap, meaning that unemployment was at target. In the widely-heralded Taylor Rule specification of the Fed’s reaction assumption, the equilibrium real rate is assumed to be 2%.

Thus, the most important question in forecasting interest rates in the years ahead, at least for me, is not the precise trajectory for either inflation or the closing of the output gap. Rather, what I want to know is whether the Fed buys Taylor’s 2% equilibrium real short-rate assumption!

I ain’t asking because I’m nosy, even if I am. Rather, I’m asking because the markets - in which I’m a significant player in the short-maturity sector — will be much more efficient conduits of the Fed’s intent if the Fed specifies more quantitatively its intentions.

And I’m not a Johnny-come-lately on this topic. Last August 1, just as the FOMC introduced "considerable period" into its lexicon, I took a strong stance on the matter of the "equilibrium" real short-term rate: it is about one-half of one percent, I believe, not two percent! Bear with me, please, for an admittedly-lengthy recitation of what I said then:

My big axe to grind long term is the 2% "equilibrium" real short rate assumption in Taylor’s Rule. Why did Taylor assume 2%? The economics profession has long assumed that the "equilibrium" real interest rate must be below the potential real growth of the economy, so as to prevent real debt service burdens from rising exponentially as a share of the economy. On its face, there is nothing wrong with this assumption. It is based on the same commonsensical notion that banks can’t sustainably pay more interest on deposits than they earn on loans. At the time of Taylor’s research in the early 1990s, the potential real GDP growth was assumed to be 2- 2 ½%.

Thus, Taylor, via Occam’s Razor, assumed 2% for the "alpha" in his Rule.

As a factual matter, the realized real short rate for the entire 1953-2001 period (picking 1953 as a staring point, a "safe" distance after the 1951 Fed Accord with the Fed that permitted the Fed to run monetary policy independent of fiscal policy), averaged 1.4%. But for the 1953-1979 period, it averaged only 0.5%. The average for the whole period was pulled up by 2.5% average for 1979-2001. And for the 1979-2001 period, the Fed was explicitly holding the actual short real short rate above its equilibrium level, as by implied by Taylor’s Rule, in which any "over-target" amount of inflation enters at 150% into the "right" nominal Fed Funds rate.

Thus, there is no empirical basis for Taylor’s assumption of a 2% "equilibrium" real short rate (it’s subject to the Lucas Critique, for those who are into this sort of stuff). I submit that there is also no theoretical support for Taylor’s assumption of an 2% "equilibrium" real short rate. If the notion holds that the economy can’t sustainably pay a real rate greater than its real growth, and I believe it does (since I believe in arithmetic!), I submit that the real interest rate that must be at or below the real growth rate is the private sector long-term real rate.

In the end, it is the private sector, not the government sector with a printing press, that is the source of real GDP growth. Or, if you will bear with me for a Republican riff, the private sector makes things, while the government sector only redistributes that which the private sector makes.

In this context, the Fed’s mission is to preserve the real purchasing power of money, not to generate a real rate of return for the holders of money. During the 1945-1971 Bretton Woods period, $35 bought an ounce of gold, year after year. Thus, the dollar was as "good as gold," literally, in that it bought the same physical volume of gold, year after year. The dollar did not , however, generate a real rate of return. Indeed, as my colleague Chris Dialynas notes, gold generated a negative real return during that period, because to hedge against the risk of Uncle Sam devaluing the dollar versus gold (raising the number of dollars necessary to buy an ounce of gold), it was necessary to actually physically hold gold, and bear the insurance and storage costs of doing so.

But I digress. My essential point is that money is different than capital . The Fed funds rate is the return on money, which has zero default risk and zero price risk: a buck is a buck is a buck. In contrast, the private sector credit carries both default risk and price risk. Thus, I believe that the "equilibrium" real short rate should not be equal to Taylor’s putative 2%, but rather equal to: (the economy-wide marginal income tax) x (the Fed’s inflation target).

Money should pay a sufficient interest rate to make holders of money whole for two taxes: the explicit tax on nominal interest income and the implicit tax of inflation. But money should not pay a real after-tax rate of return! In the long run, the economy can "afford" to a pay return only on capital that is at risk.

Thus, I don’t buy that the "neutral" Fed funds should be 4% if unemployment is at 5% and inflation is at 2%, as suggested by Taylor’s Rule. Rather, I think the "neutral" nominal Fed funds should be 1 + .2% (a high side-estimate for the economy-wide marginal income tax rate) times the Fed’s 2% inflation target: 2.4%.

What would that imply for the slope of the yield curve? If (1) the private sector long-term real rate "needs" be at or below the economy’s potential growth real rate of 3%, and if (2) the 10-year swap spread is about 60 basis points, as at present, then (3) a ten-year real Treasury rate of 2.4% "drops out." And if we add to that real rate a 2% inflation rate, the Fed’s putative definition of "price stability, we end up with an "equilibrium" nominal 10-year Treasury of 4.4%. Such a rate would be consistent with the 2.4% "equilibrium" nominal Fed funds rate that "my" Taylor rule posits. Remember, these are levels consistent with unemployment at 5% and inflation at 2%, not today’s levels of 6.2% and 1.2%, respectively.

Yes, such "equilibrium" yield levels would imply a steep yield curve. To my way of thinking, however, this is the way it should be. The front end of the yield curve is about money ; the long end of the curve is about capital . In a world of winning the peace of "price stability" after a two decade-long war against inflation, money should be a reliable "store of wealth," not a generator of real wealth. In a world of "price stability," investors must accept - and the Fed must enforce! - the proposition that real returns can come only with the taking of real risk.

By definition, however, once reflationary policies beget reflationary consequences, it will be time for the Fed to dilute the ink supply for its reflationary printing press. Such a change will ineluctably involve bursting of asset price bubbles, as those who have bet that the Fed would fail in its reflationary efforts are compelled to reduce portfolio risk and leverage. This is the biggest challenge presently confronting the Fed: the exit strategy from a 1% Fed funds rate, when it is no longer prudent.

I believe, and believe strongly, that the exit would be prudently lubricated by the Fed quantitatively revealing its reaction function. Most urgently, the Fed should tell us its definition of the "neutral" — or equilibrium — real short-term interest rate. Professor Taylor says, 2%. I say, 50 basis points. It is time for Mr. Greenspan to say what he believes!

Or in the words of a hero of mine who just entered the Rock and Roll Hall of Fame two weeks ago:

Doctor, my eyes
Tell me what is wrong
Was I unwise to leave them open for so long
‘Cause I have wandered through this world
And as each moment has unfurled
I’ve been waiting to awaken from these dreams
People go just where they will
I never noticed them until I got this feeling
That it’s later than it seems
Doctor, my eyes
Tell me what you see
I hear their cries
Just say if it’s too late for me
Doctor, my eyes
Cannot see the sky
Is this the prize for having learned how not to cry?

- Jackson Browne

Paul McCulley
Managing Director
March 30, 2004

1 "Needed: Central Bankers with Far Away Eyes," Fed Focus, August 2003. /LeftNav/Late+Breaking+Commentary/FF/2003/FF_08_2003.htm


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