Visions of economic recovery cold-cocked the fixed income market during November, as the market reduced its expectations of (1) how low the Fed-controlled Fed funds rate will go, and (2) how long it will stay low. The market is now romancing a V-shaped recovery for the economy, to be mirrored by a V-shaped journey for Fed funds. More specifically, as vividly displayed in Figure 1 below, the forward curve for 3-month LIBOR is now “pricing in” 150 basis points (or more) of Fed tightening in 2002. I think the forward curve is wrong.

Beware The Forward At Fed Turning Points

Figure 1 is a line graph showing three-month LIBOR (the London Interbank Offered Rate, a common short-term interest rate benchmark) from 1986 through late 2001, with projections through 2003. At 26 November 2001, three-month LIBOR and is at around 2.25%, close to the fed funds rate. But going forward, the projection of 3-Month LIBOR through 2002 and 2003 rises to about 5% by the end of 2003, slightly above the forecast trajectory of the fed funds rate. The metric has trended down over time, from a peak of about 10% in 1989. The chart highlights trajectories of the fed funds rate from the last easing of a given cycle, shown in green, and the last tightening, shown in red. In November 2001, the trajectory since the last easing is lower than that of the expected trajectory of 3-Month LIBOR.

Figure 1
Source: Bloomberg

But I’m not surprised by what the market has done, just by the viciousness with which it has done it. Both the record of post-WW II business cycle history and the Fed’s own words this year scream that the Fed ineluctably tightens once recession-induced easing has produced recovery. More specifically, the record of the seven recession/recovery cycles since WW II, as displayed in Figures 2 and 3, indicates that the Fed switches from easing to tightening a few months after the unemployment rate has peaked, which tends to happen some six months after the manufacturing sector has troughed.

The Record Of The Seven Post-WW II
Recession/Recovery Cycles Is That The
Fed Doesn’t Tighten Until After The
Unemployment Rate Has Peaked...

Figure 2 is a line graph (with data through November 2001) showing the average change in the fed funds relative to the months before and after the U.S. unemployment rate has peaked. The change in the fed funds rate is shown on the Y-axis, and the months before and after the unemployment peak are shown on the X-axis. The time of zero months, of a peak in unemployment, is represented by a dashed vertical line. Before then, from negative 12 months to zero, the average change in fed funds is positive, but slopes downward, from a peak of around a change of 3.5 percentage points 10 months before, down to just less than slightly less than zero two months after the unemployment peak. As the change in unemployment rate declines after its peak, to about negative 2 percentage points 24 months after the peak in unemployment, the change in the fed funds rate rises to almost one percentage point.

Figure 2
Source: Bureau of Labor Statistcs

... Which Is Some Six Months After The
Manufacturing Sector Has Troughed

Figure 3 is a line graph (data through November 2001) showing the average change in the fed funds rate and the index for the National Association of Purchasing Management relative to the months before and after the peak of the cyclical U.S. unemployment rate. The change in the fed funds rate is scaled on the right-hand vertical axis, the NAPM index on the left-hand vertical axis, and the months before and after the peak in the unemployment rate on the X-axis. At the time of zero months, the Purchasing Management index is in a steep climb upwards, crossing the key threshold of 50, a level of which is represented by a horizontal dashed line. The index bottoms at around 42 six months before the peak in unemployment, and rises to a peak of about 61 eight months after. Before then, from negative 12 months to zero, the change in fed funds is positive, but slopes downward, from a peak of around a change of 3.5 percentage points 10 months before, down to just less than zero two months after the unemployment peak. As the change in unemployment rate declines after its peak, to about negative 2.0 percentage points 24 months after the peak in unemployment, the change in the fed funds rate rises to almost one percentage point.

Figure 3
Source: Bloomberg, National Association of Purchasing Managers:

If we assume that the manufacturing sector is troughing right now, as inventory liquidation reaches a nadir, history would suggest that the unemployment rate will peak by the middle of 2002, with the Fed beginning a tightening campaign by the end of 2002. Note, I said this is the path that history suggests will end in Fed tightening, not the one I expect to unfold. I don’t, for secular reasons I will strongly argue shortly, expect any Fed tightening at all in 2002. But as a portfolio management matter, it would be irrational for me to think the market will share my expectation. Markets rarely, if ever, discount secular change at cyclical turning points. Rather, they extrapolate the contours of prior cyclical turning points.

The record of history says that once the trough for the manufacturing sector is in sight, the market should start demanding a yield premium for the risk of Fed tightening. What is more, the FOMC has been openly warning since June that it is prepared to reverse course quickly. At its June 27 meeting, the FOMC declared:

“With greater slack in labor and product markets, and with inflation expectations contained, an added easing ran very little risk of exacerbating price pressures, provided the Committee was prepared to firm the stance of policy promptly if and when demand pressures threatened to intensify.”

At its August 21 meeting, the FOMC re-iterated that message:

“Beyond the nearer term, members envisaged the desirability of moving preemptively to offset some of the extra monetary stimulus now in the economy in advance of inflation pressure beginning to build.”

And then at its October 2 meeting, the last for which minutes have been released, the FOMC bellowed:  

Monetary policy is a flexible instrument and, with inflation expectations likely to remain relatively benign, policy could be reversed in a timely manner later should stimulative policy measures and the inherent resiliency of the economy begin to foster an unsustainable pace of economic expansion.”

It is not a surprise that the market is romancing the notion of a “take back” of some of this year’s easing, once recovery is underway. History says the Fed will, and the FOMC’s own recently repeated words reveal an innate desire to do just that. November’s nasty bond bear was not immaculately conceived. We know its parents. But now that the forward market is fully “pricing in” the risk that the Fed gets nasty in 2002, it is time for all good investment professionals to bring secular analysis to the aid of their portfolios.

There are two key secular reasons to believe that the market is over-estimating both the timing and the magnitude of an eventual cyclical reversal to Fed tightening: (1) secular price stability has been achieved, rendering the concept of “opportunistic disinflation” an oxymoron; and (2) the Fed believes, and in particular Mr. Greenspan believes, that a positive secular shock to productivity growth is still unfolding.

Remembering (And Burying) "Opportunistic Disinflation"
Economists have a tendency to label things, processes and just plain stuff in such a fashion as to make non-economists’ eyes glaze over. I plead guilty, and reader feedback suggests that I may actually be guilty more often than I’m willing to admit. But what the hey, every profession has its own vocabulary. The Los Angeles Lakers play something called the “triangle offense,” which I’ve never quite understood, except that it works. For the last decade, the Fed has played something called “opportunistic disinflation,” and it, too, has worked.

The term actually entered the public arena on July 10, 1996, when the Wall Street Journal leaked an internal Fed report by staff economists Orphandies and Wilcox, detailing the Fed’s “new” approach to inflation-fighting: the Fed should not take deliberate action to reduce inflation, but rather “wait for external circumstances – e.g., favorable supply shocks and unforeseen recessions – to deliver the desired additional reduction in inflation.”

Simply put, the theory said, the Fed should not deliberately induce recessions to reduce inflation, but rather “opportunistically” welcome recessions when they inevitably happen, bringing cyclical disinflationary dividends. A corollary of this thesis was that the Fed should pre-emptively tighten in recoveries, on leading indicators of rising inflation, rather than rising inflation itself, so as to “lock-in” the cyclical disinflationary gains wrought by recession. While the label “opportunistic disinflation” was a clever one, the Fed had actually been practicing the policy for a long time. Indeed, former Philadelphia Fed President Edward Boehne elegantly described the approach at a FOMC meeting in late 1989:

“Now, sooner or later, we will have a recession. I don’t think anybody around the table wants a recession or is seeking one, but sooner or later we will have one. If in that recession we took advantage of the anti-inflation (impetus) and we got inflation down from 41/2 percent to 3 percent, and then in the next expansion we were able to keep inflation from accelerating, sooner or later there will be another recession out there. And so, if we could bring inflation down from cycle to cycle just as we let it build up from cycle to cycle, that would be considerable progress over what we’ve done in other periods in history.”

What Mr. Boehne didn’t address in 1989, or the Fed staff economists in 1996, is what the Fed should do once secular “opportunistic disinflation” had succeeded in generating “price stability,” defined most famously by Fed Chairman Greenspan as an inflation rate so low as that it no longer enters into the long-term decision-making process of households and businesses. “Opportunistic disinflation” was a cyclical strategy for the Fed dog to catch the secular “price stability” bus; but the theory offered no guidance as to what the Fed should do, once it caught the bus.

The Fed has now caught the bus, as vividly displayed in Figure 4. Accordingly, “opportunistic disinflation” is now an oxymoron: from a starting point of secular “price stability,” a recession doesn’t pay disinflationary dividends, but deflationary defaults. Such is the case at the moment, notably in globally-traded goods and services. Thus, the case for pre-emptive cyclical Fed tightening has also become an oxymoron.

With Secular Victory Over Inflation,
"Opportunistic Disinflation"
Becomes An Oxymoron.

Figure 4 is a line graph showing the year-over-year percentage change in the U.S. Personal Consumption Expenditures (PCE) Price Index from 1970 to 2002. The metric trends downward over the last two decades, reaching a chart low of less than 1% in late 2001, down from its last peak above 11% around 1980. It also peaks around the same level in 1974. It drops sharply after 1980, down to a low of about 2% in the mid-1980s, then rises to a lower peak of about 5.5% in 1990. It then falls to a low of about 1% in 1998, before rising to another lower peak of about 3.5% in 2000. The chart also shows steep declines during recessions. A five-year moving average shows a smoother trajectory, of a peak of just above 8% around 1982, before trending down to a chart-low of about 2% by 2000.

Figure 4
Source: Bureau of Economic Analysis

Once secular “price stability” has been achieved, the Fed mission must morph into “allowing” inflation to cyclically fluctuate: a recovery-induced lift in inflation (notably in globally-traded goods and services prices) is not to be feared nor pre-empted, but rather welcomed, as the truncating of deflationary risk. One hundred and fifty basis points of Fed tightening in 2002, as the forward curve now discounts, would be a blatantly deflationary act. The Fed ain’t going to do it; wouldn’t be prudent.

Remembering (And Nurturing) New Age Productivity Growth
Fed Chairman Greenspan coined the phrase “irrational exuberance” in December 1996. But only seven months later, at the July 1997 Humphrey Hawkins hearings, he started musing about the possibility that the on-going investment boom, notably in technology, might be a “once or twice in a century phenomenon that will carry productivity trends nationally and globally to a new higher track.” Ever since, Mr. Greenspan has been an evangelist for the notion that the surge in productivity growth in the second-half of the 1990s was not just a cyclical phenomenon, but a secular phenomenon, marking the beginning of a permanently higher trajectory.

Indeed, Mr. Greenspan was at his most evangelic-self on this topic in January of this year, when he openly advocated (to the great joy of the new Bush White House!) secular cuts in income taxes, so as to prevent a too-rapid pay down in the federal debt, stoked by a productivity-induced bounty in growth. Specifically, he said:

“Reflecting the uncertainties of forecasting well into the future, neither the OMB nor the CBO projects productivity to continue to improve at the stepped-up pace of the past few years. Both expect productivity growth rates through the next decade to average roughly 21/4  to 21/2  percent per year—far above the average pace from the early 1970s to the mid-1990s, but still below that of the past five years.

As the CBO and the OMB acknowledge, they have been cautious in their interpretation of recent productivity developments and in their assumptions going forward. That seems appropriate given the uncertainties that surround even these relatively moderate estimates for productivity growth. Faced with these uncertainties, it is crucial that we develop budgetary strategies that deal with any disappointments that could occur. That said, as I have argued for some time, there is a distinct possibility that much of the development and diffusion of new technologies in the current wave of innovation still lies ahead, and we cannot rule out productivity growth rates greater than is assumed in the official budget projections.”

Those are the words, friends, of a man who believes in the New Age productivity miracle! The fact that the economy has now been declared to have been in recession since March is no doubt disappointing to Mr. Greenspan. But my hunch, and it is a strong hunch, is that Mr. Greenspan still believes much of what he preached about productivity back in January. In fact, on October 17, he declared:

“Although it is difficult to determine with any precision, it seems quite likely that a significant re-pricing of risk has already found its way into our markets, as many economic decisions are responding to shifting market signals. But these adjustments in prices and in the associated allocation of resources, when complete, represent one-time level adjustments, without necessary implications for our longer-term growth prospects.

Indeed, the exploitation of available networking and other information technologies was only partially completed when the cyclical retrenchment of the past year began. High-tech equipment investment at elevated rates of return will, most likely, resume once very high uncertainty premiums recede to more normal levels.

The level of productivity will presumably undergo a one-time downward adjustment
as our economy responds to higher levels of perceived risk. But once the adjustment is completed, productivity growth should resume at rates in excess of those that prevailed in the quarter-century preceding 1995.”

Taking Mr. Greenspan as a man of his word, recovery from the current recession is not something to be feared on the inflation front, but something to be cheered on the productivity front. He’s still a New Age, pro-growth man. Indeed, he’s a little too New Age for PIMCO thinking. But he is what he is, and he’s got the data on his side, as displayed in Figure 5. One hundred and fifty basis points of Fed tightening in 2002, as the forward curve now discounts, reflects very Old Age thinking. Greenspan ain’t going to do it; read his lips (not the FOMC’s).

Greenspan's Enthusiasm For Productivity
May Be Exaggerated, But It Isn't All Wrong

Figure 5 is a line graph showing the year-over-year percent change in U.S. non-farm productivity, from 1954 to 2002. The chart shows rapid and significant changes over time, ranging from negative 2% to positive 7%, but it becomes less volatile over the latest two decades. A five-year moving average shows a smoothed-out path, rising to about 2.5% by late 2001, up from its most recent low of about 1.5% in in 1990. The five-year moving average peaks in the late 1960s, at almost 4%, then trends downward to a chart low of about 0.5% in the early 1980s. The chart also shows productivity rising rapidly at the end of U.S. recessions.

Figure 5
Source: Bureau of Labor Statistics

Bottom Line
With the recession now nine months old and massive Fed easing behind us, the fixed income market is replaying nightmares of a Fed tightening “take back.” From a trading perspective, this is understandable: history repeats itself until it doesn’t. From an investment perspective, however, anticipating secular change is where the real money is made.

With secular victory over inflation achieved, and with secular productivity promises to be pursued, Greenspan has tightened for the last time of his career.

Paul A. McCulley
Managing Director
November 28, 2001


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