Don’t Shoot Ben and Don’t Short Bonds

Allow us to share with you an open secret. Ben Bernanke, the new-ish Chairman of the Federal Reserve, is not only one of the foremost economists of his generation; he is also one of the clearest speakers in a profession whose practitioners are often tongue-tied as well as three-handed. So it has come as something of a surprise that in the six months since Mr. Bernanke returned to the Fed, many have accused the new chairman of having a communications problem, a difficulty getting his point across, and in the eyes of some critics, a flip-flop tendency.

Against that backdrop, Mr. Bernanke’s July 19 testimony on the Fed’s semi-annual monetary policy report to Congress was a masterful performance. True, he had the benefit of a dress rehearsal on February 15-16, when he gave what was essentially the last stanza of the Greenspan era – the monetary policy report based on the outlook discussed at the January 31 meeting of the Federal Open Market Committee on Mr. Greenspan’s last day at the office.

This time, while Mr. Bernanke was undoubtedly speaking on behalf of his colleagues on the FOMC, there was no doubt that this is now the Bernanke Fed. We got an explanation, as clear as can be, that central banking is a forward-looking game. Borrowing from Milton Friedman’s famous dictum that “monetary policy works with long and variable lags,” Mr. Bernanke told the Senators and Congressmen:

“The lags between policy actions and their effects imply that we must be forward-looking, basing our policy choices on the longer-term outlook for both inflation and economic growth. In formulating that outlook, we must take account of the possible future effects of previous policy actions – that is, of policy effects still ‘in the pipeline’.”

The Meaning of “Data Dependence”

Central banking is the art and science of decision-making under uncertainty. Policymakers at the Fed and elsewhere must base interest rate decisions on their expectation of where the economy is going, not just where it has been. Monetary policy by necessity is explained by reference to the economic forecasts and a reaction to shocks. Yes, as Fed policymakers remind us, monetary policy decisions are data- driven. But the importance of the data lies in its implications for the forecast and the extent to which the data confirm or disconfirm the committee’s best guess about the direction in which growth and inflation are headed.

It is no surprise that monetary policy decisions are hardest to make, and to explain, when the economic and interest rate cycles are at a turning point. Alan Greenspan, you might say, got out just at the right time – and you can’t help wondering if he planned it that way! It is inevitable that in a period of “transition,” to use Mr. Bernanke’s phrase, that there will be tension between the incoming data and the forecast. Core inflation of late has been higher than the FOMC expected but there is also unambiguous evidence that the housing market is cooling. Mr. Greenspan might even have had trouble in this current environment, though of course there are great benefits of having established a strong track record over 18½ years, not least the fact that when you say, “just trust me” people may be inclined to do so.

For all the talk of their differences, which mainly refer to communication styles and philosophies, there is a great similarity between Mr. Bernanke and Mr. Greenspan’s approach to monetary policy. They share a belief in a gradualist approach to policymaking, when this is possible, and you can’t get much more gradualist and predictable than the 425 basis points of tightening that the Fed has spread out over two years.

But that period is over, as Mr. Bernanke tried to explain on April 27, before Congress’s Joint Economic Committee, to loud booing from market participants who had grown accustomed to Fed guidance based on a Greenspanian turn of phrase. While Mr. Bernanke will surely spin some clever rhetoric from time to time, his essential approach will instead be to lay out the details of the Fed’s forecast and reaction func- tion, and over time to introduce a quantitative anchor in the form of a more clearly-specified medium-term inflation objective.

Faced with a high level of uncertainty, the central banker’s playbook says be cautious and go slower, courtesy of an influential paper written by William Brainard¹ – one that Mr. Bernanke drew upon when explaining the Fed’s gradualist approach in a speech just before the central bank embarked on this tightening cycle.² A golfer ahead on the final green may choose to lag a couple of putts, rather than shooting for a birdie. Mr. Bernanke perhaps had this in mind during his testimony before Congress’s Joint Economic Committee in April, when he told the law-makers: 

“Even if in the Committee’s judgment the risks to its objectives are not entirely balanced, at some point in the future the Committee may decide to take no action at one or more meetings in the interest of allowing more time to receive information relevant to the outlook. Of course, a decision to take no action at a particular meeting does not preclude actions at subsequent meetings.”

That April testimony went down like a shot dove, with tired old accusations that Mr. Bernanke, one of the leading proponents of inflation targeting, is somehow soft on inflation. Three months later Mr. Bernanke repeated in effect the same message and this time received bouquets. Indeed, Senator Paul Sarbanes kindly invited Mr. Bernanke to be explicit on the point, asking him whether he concurred with a statement made by Mr. Greenspan at the end of the 1994-95 tightening cycle – when the former Fed chairman said:

“There may come a time when we hold our policy stance unchanged or even ease despite adverse price data should we see signs that underlying forces are acting ultimately to reduce inflation pressures.”

We liked Mr. Bernanke’s reply:

”I absolutely agree with your point, Senator. In fact, in my testimony before the Joint Economic Committee, I argued that at some point, a point which I did not specify, the Fed would have to get off this 25-basis-point-a-meeting escalator and adopt a more flexible approach, possibly varying its pace of tightening, possibly taking a pause. That has been the practice in the past; that’s the practice of the European Central Bank and the Bank of Japan today… We always look at this meeting-by-meeting. And we will be evaluating all options when we come to meet in August.”

The Forecasts

If you are explaining where you think the economy is headed then it makes sense to have a forecast on an easel next to you. The consen- sus forecasts of the FOMC, released as part of the monetary policy report to Congress, and displayed in Exhibit 2, show that the Fed has marked to market the higher than expected core inflation of recent moves. But the committee does not think that an inflationary process is underway that will bring sustained accelerating inflation. Rather it sees core inflation as temporarily boosted by the direct pass through from high energy prices – which should wash out if energy prices stabilize – and from the much discussed Owners Equivalent Rent com- ponent of core inflation measures. With growth moderating, it expects inflation to moderate.

 

Of course the timing is not closely aligned. That rarely happens. The typical monetary policy cycle is one in which rate hikes impact aggregate demand and in turn the output gap and then, with a lag, inflation. A central banker who chases inflation up the hill, economy is heading down the other side, risks taking a tumble on behalf of all of us.

The committee’s forecasts see growth slowing from an above-trend rate in the first half of the year to a below-trend rate in the second half, but to stabilize at close to its non-inflationary potential rate next year. And for core inflation to be a bit higher than expected but then to trend down in the second half of next year as transitory factors wash out.

It is clear that Mr. Bernanke wants to use the forecasts more than his predecessor in explaining policy decisions in the context of the Fed’s reaction function. This will be a quantitative approach rather than the qualitative approach of signaling the rate decisions likely at forthcoming meetings. That guidance was possible as the Fed normalized monetary policy following its emergency rate cuts to 1%, but it is an approach that is no longer possible nor desirable. In fact, it could be toxic.

The logic of Mr. Bernanke’s approach suggests that he will soon push for the Fed to start releasing the FOMC’s forecasts on a quarterly basis, rather than twice-yearly, and to keep them fresh. And for the forecasts to be truly useful, we believe the committee should make clearer the path for the Fed funds rate that committee members have in mind. Or if that is seen as too radical, the committee could use financial market expectations as the basis for the forecast, Bank of England style. In any event, it is clear enough from the statements and the minutes that whatever further rate increases the FOMC members were penciling in when coming up with their forecasts ahead of the June meeting, they were not assuming much more – if any – in the way of rate hikes.

Crucially for any central bank and particularly one prepared to focus on core inflation rather than headline inflation boosted by energy prices, inflation expectations must remain well contained – measured by the TIPS market or by the surveys. Following the brief upward blip earlier in the year, in the context of slowing growth, the Fed’s June hike can be seen as inflation expectations and credibility induced. It was not fundamentally needed per se, based on the forecasts, as well as stark evidence of a nasty turn in housing (see Exhibit 1). Rather, that last hike must be seen as a punctuation point, a rebuke for anyone who questioned the Fed’s resolve to maintain the peace of price stability.

For, again in common with his predecessor, Mr. Bernanke is a risk-manager. After essentially explaining the forecast-based case for a pause in his recent testimony, educating the lawmakers and everyone watching on CNBC, he added for good measure:

“We must consider not only what appears to be the most likely outcome but also the risks to that outlook and the costs that would be incurred should any of those risks be real-ized… Because economic forecasting is far from a precise science, we have no choice but to regard all our forecasts as provisional and subject to revision as the facts change. Thus, policy must be flexible and ready to adjust to changes in economic projections.”

To be sure, the risk management approach and the nagging concern that core inflation will remain above the FOMC’s forecast level sug- gest that another risk-management inspired rate increase remains an option.

But it is clear from the minutes of the FOMC’s June meeting, released the day after Mr. Bernanke’s testimony to Congress, that while there was a unanimous vote to raise the Fed funds rate another notch to 5.25%, the committee agonized more than a bit about the decision. And rationally so, as it was the first time in 23 years the Fed hiked the Fed funds rate through the entire Treasury yield curve.

Bottom Line

The logic of a forward-looking approach to policymaking and the Fed’s forecasts themselves whispered, “pause” in June. Data released since then, and the market’s warm embrace of the Fed’s tough love in June, now shout not just “pause,” but “stop!” And that’s the case in spite of the 0.3% print on the latest core CPI. As Mr. Bernanke told the Senators, there is not much the Fed can do about last month’s inflation number. As the housing market rolls over, downside risks to growth must rise in importance in the eyes of responsible, forward-looking central bankers. With all due respect to Mae West, too much of a good thing is not always a good thing.

Indeed here at PIMCO we believe the Fed has already gone too far. That means it is likely to reverse course within the next 6-9 months, in line with past experience – even though this has been a very different cycle. As Bill Gross intoned in his August Investment Outlook, the Fed tightening-inspired bear market in bonds is over.³ A new bull market is underway. Easing, probably serious easing, is coming into view on a 2007 horizon. Our clients’ portfolios are positioned accordingly.

Paul McCulley
Managing Director
mcculley@pimco.com

Andrew Balls
Senior Vice President
andrew.balls@pimco.com

July 31, 2006

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