Global Central Bank Focus

Just‑Right Ben?

There is a limit to how long we in the bond market will be willing to invest long-term at lower interest rates than for parking cash overnight in the bank.


conversation with Morgan le Fay, the author’s family pet and early-morning debating partner)


PM: Good morning, Morgan. It’s that time of the year again, Princess, when we chin wag about the year that is ending and opine about the coming year. As always, thanks for agreeing to do this with me.

And let me say upfront, you are as gorgeous as ever, as you approach nine years. Time has been good to you, Morgan.  

MLF: Thanks, dude. My narcissistic streak appreciates the praise, though I must say I would be in even fitter shape if you had not moved us from down on the Peninsula to up here on the Hill over the summer. Down there, I got to run around on the patio beside the water, but up here, I gotta live in this hutch.  A nice hutch, to be sure, a duplex with cool ladder steps and an asphalt roof. But I am no longer able to run free, keeping me svelte and fit.  

PM: Understand that Morgan, but there were no coyotes or bobcats down on the Peninsula, while both are in abundance up here on the Hill. So what must be must be. And if you’ve gotta live in a hutch, you’ve got a really cool one, made custom just for you by my colleague Devon and her dad. Wanta turn to serious talk now?  

MLF: Ok, but didn’t we do that back in September, in a one-off after you got back from Jackson Hole? Shouldn’t we roll together a discussion of what we thought a year ago and what we learned in Jackson Hole?

 PM: Wise bunny, Morgan, very wise. Our core thesis last December was that:

  • The air was going to come out of the housing boom, with a more nefarious whooshing sound than consensus was projecting, with volume of transactions crashing, a dramatic slowing in housing price appreciation, and pockets of outright deflation.
  • The end of soaring property prices would put the Half Nelson on the ability of households to extract equity from their homes, a technique called MEW, which makes the home a de facto ATM, and would dampen consumption growth to be more in line with income growth, stabilizing if not lifting the personal savings rate.
  • The Fed would stop tightening once it was clear that the real estate market was crying uncle and that a year ahead – i.e., now! – the dominant topic of discussion in the markets would be when the Fed would be reversing to easing.

MLF: What do you mean “we”, Mac? If I recall, it was me, not we, that pounded the table about the nasty nature of that MEW thing. Reminded me of a cat and you know how much I hate cats, as they are always seeking to eat me. So, seems to me that you owe me a Christmas bonus.  

PM: No problem, Princess; I’ll wire it directly into the just-established Morgan Le Fay Dreams Foundation; I promise to be a faithful servant of your charity work. Meanwhile, back to the topic at hand: we got the housing bust right, but so far, the drag from MEW hasn’t been quite as nasty as we thought.  Americans’ spending may have lost a bit of glow, but it is still pretty sturdy, on the back of still sturdy job and wage growth. Just proves yet again that it is a dangerous proposition to short American hedonism.  

MLF: Living here in Orange County, you should know that, Mac! In any event, let’s talk about that Fed call. Yes, the Fed did stop tightening, but later and at a higher Fed funds rate than you forecast. And the Fed is still biased to tighten. So, don’t you think now would be a good time for you to eat some humble crow?  

PM: With mustard, Princess, I most certainly will. I simply underestimated the Fed’s concern about inflation over its putative 1%-2% comfort zone for the core PCE deflator. Flagging housing eventually got them to stop tightening, but even after Chairman Bernanke introduced the word “pause” to the Fed’s lexicon, they snuck in two more rate hikes. Not that I’m terribly critical, as soaring commodity prices in the spring did signal that inflationary expectations might be slipping from their price-stability moorings. Guess you could say that the commodity markets were testing Mr. Bernanke’s manhood.  

MLF: In that case, then, Mac, does the inverted yield curve and shrunken inflation breakevens in TIPS say that Gentle Ben passed the test, that he is a man among boys, except perhaps that Lacker fellow from your home state of Virginia, who wants to tighten until the last dog dies?  

PM: Fair conclusion, Morgan, very fair. Indeed, to my mind, there is no more compelling evidence of a central banker’s anti-inflation credibility than an inverted yield curve. To me, it axiomatically says that short rates have been lifted not just to neutral but to restrictive, which will bear down on growth and, with a lag, inflation.  

MLF: Yep, that’s what the textbooks say and Mr. Bernanke is certainly a man of textbooks; in fact, he wrote one. But didn’t you tell me after coming back from Jackson Hole that some of the textbooks are being re-written, to reflect a flattening of the Phillips Curve, the result of globalization?  

PM: Yea verily, I did, Princess. You have a great memory. Essentially, a flatter Phillips Curve means that you get less of an inflationary impulse from above-potential growth but also less of a disinflationary impulse from below-potential growth. So it’s a good news-bad news story.  

MLF: Call me mad cap, or whatever you want, but that sounds like a good news story to me: says on average that America can run a lower unemployment rate than historically the case, without an endemic inflationary problem. Am I missing something?  

PM: Not at all, Morgan, when thinking in secular terms. You are spot on! Cyclically speaking, however, a flatter Phillips Curve means that central bankers might be tempted to let the economy run too hot for too long, given the muted inflationary consequences, and then find that they have to run the economy cooler for longer to reverse even that muted inflationary consequence.  

MLF: Well, from what you heard at Jackson Hole, it would seem that Chairman Bernanke knows that, so he’s unlikely to make that mistake. Perhaps I should give him a new nickname: Just-Right Ben, rather than Gentle Ben. 

PM: Not sure if we have enough evidence to come to that conclusion quite yet, Morgan, but I think it’s a good forecast. Much will depend on just how long the Fed is willing to remain restrictive, with an inverted yield curve.

For, you see, an inverted yield curve is not a normal configuration but rather an explicit bet by the bond market that the Fed will be reversing course, cutting short term interest rates. And an ebullient equity market, as we’ve certainly had, is the same bet, even if not quite as explicitly so. Bottom line, Morgan, both bonds and stocks are pricing for an economic soft landing, not a recession, with the landing strip lubricated by Fed easing.

MLF: Then why is the Fed ignoring the markets and still sermonizing about the possibility of yet further tightening? If they did, wouldn’t that totally destroy risk appetite in the bond and equity markets, dramatically increasing the risk of a recession? In mountain climbing, I’m told, there is a thin line between courage and stupidity. Does the same thing hold in central banking? Isn’t the Fed skirting just a little too close to that line?

PM: Skirting, yes, Morgan, but not over that line, I don’t think. But it is indeed a tricky proposition, as there is a limit to how long we in the bond market will be willing to invest long-term at lower interest rates than for parking cash overnight in the bank. Ultimately, for the soft landing scenario embedded in current bond and stock valuations to be realized, the Fed will need to validate the markets’ easing expectations.

MLF: So will they?

PM: Yes, Morgan, I believe the Fed will, as the property market, as well as the motor vehicle industry continue to weigh on growth, especially in manufacturing. Remember, my single favorite economic indicator is the ISM Index, and when it goes below 50, as it recently did, it’s a very prescient signal of easing to come.

MLF: But what if the housing and car industries get a quick grip on themselves, as the overhang of inventory in both sectors is worked quickly down? In that case, could the Fed just wait it out for a growth rebound?

PM: Conceptually, yes, Princess, but as a practical matter, you won’t get the growth rebound if the bond and stock markets conclude that the Fed is going to refuse to ease, unwinding the easier financial conditions that the markets have been gifting to the economy in recent months. The promise of ice cream can only sustain a child’s giddiness for so long; ultimately, parents do have to validate that promise with a trip to the Dairy Queen.  

MLF: Are you suggesting that the bond and stock market players are petulant children? I thought what you do for a living is an adult's game. It’s not?  

PM: No, Morgan, your prior is right: it is an adult's game. But there is only one player in the game that is legally entitled to print money, and that is the Fed. Thus, short-term interest rates are not market-determined but rather the result of a fiat decision by the Fed. Thus, we adults in the private sector must anticipate what the Fed will do with its awesome fiat power. We really have no choice. And right now, we are collectively choosing to believe that normality will be restored to the yield curve with the Fed lowering short rates below the level of long rates that we determine in the market.   If that collective belief were to be proven wrong, then bonds and stocks would have to bearishly re-price, tightening financial conditions and weakening the economy, particularly housing.  

MLF: So, you’re saying the markets are smarter than the Fed?  

PM: Not necessarily, Morgan, though at cyclical turning points in the economy, evidence would tend to support that thesis.   In an ideal world of perfectly rational expectations, as St. Louie Fed President Poole preaches, the Fed and the markets would have a perfect marriage, with the Fed’s reaction function printed on a black board and with both the Fed and the markets reacting exactly the same way to incoming information. But as Mr. Poole would be the first to say, that’s not the real world, even though it’s closer to the real world than it was years ago, when the Fed was about as transparent as the plywood backing on your hutch.  

MLF: Still not sure I’m following you: both the Fed and the markets are presently looking at precisely the same public data, even though the Fed might have some proprietary information from all its business contacts in the regions. But having heard you read that Beige Book aloud to me, I don’t think the Fed’s anecdotal information is really all that much better than what you guys in the private sector have. So, is the disconnect between the markets discounting easing and the Fed preaching tightening risk really a matter of lack of a mutual understanding of the Fed’s reaction function?  

PM: Very, very good, Princess! You are one smart bunny. And the disconnect is, I think, that the markets don’t believe that the Fed’s comfort zone for inflation is really 1%-2% for the core PCE deflator, even though Fed officials preach that it is. Thus, it seems to me, the markets are more focused on below-trend growth as a catalyst for easing while the Fed is preaching that below-trend growth is justification for easing if, and only if, such sluggishness pulls the inflation rate back down into the comfort zone, from its near 2½% present level.  

MLF: Maybe, though I’m not quite so sure. You’re right, I think, as you and I discussed when you got back from Jackson Hole, that the Fed policy makers are less religious about that 1-2% comfort zone than they sound. After all, they stopped tightening with inflation above that zone, showing proper sensitivity to both the faltering property market and the lagging nature of inflation to growth.  

So let me offer an alternative thesis: there is a disconnect between the markets’ pricing of easing and the Fed’s rhetoric because the Fed needs to see not just a nasty property market but also rising unemployment. So, it ain’t that the Fed wouldn’t be willing to ease with inflation above the comfort zone, but it needs to see a rising unemployment rate, not just swooning housing markets.  

PM: You make an excellent point, Morgan. Indeed, my colleague Saumil Parikh has been doing some great work on the lag between flagging property markets and employment in the construction industry, and the evidence is pretty compelling: construction employment significantly and seriously lags housing per mits and starts, as the existing stock of starts is completed.  

Unlike the case with an auto factory, which can simply shut down the assembly line and stop making cars on the wire, builders can’t do that; they have to complete work-in-progress. And as anybody who’s ever been involved in building or renovating a home knows, work in progress is a very long, if not painful, process. In fact, here are two graphs from Saumil that speak volumes as to the lag between falling permits and starts and falling construction employment. 

Figure 1 shows the smoothed six-month growth rate for U.S. housing permits and housing under construction, from 1986 to 2007. While the two metrics roughly track each other during the period, the chart shows that the line for housing permits is more volatile, and has about a five-month lead. For example, the metric nears a bottom in late 2006, at negative 30%, when housing under construction is at negative 20%. At this part of the graph, both metrics either reach or break new lows. For most of the time period, the growth rate in housing permits fluctuates between negative 10% and positive 15%. For housing under construction, growth typically ranges between negative 10% and positive 10%.

Figure 2 is a chart showing smoothed, six-month growth rates of U.S. construction employment and housing under construction, from 1986 to 2007. The chart shows how housing under construction has about a three-month lead on the payroll metric. For example, near the end of 2006, housing under construction plummets to a low of nearly a negative 20% six-month growth rate, while construction payrolls are only at zero growth. The last time the metric was this low was in 1991, when it was in excess of negative 20%. Over the period show, growth in housing permits typically range between negative 3% and positive 10%, while construction payroll growth ranges between negative 7% and positive 8%.

MLF: Ah, so it really is true that a picture paints a thousand words! Permits lead construction by five months, as work in progress is built out, and construction leads construction jobs by three months. In this cycle, permits peaked about a year ago, construction’s contribution to GDP growth went decidedly negative in the spring and summer and construction payrolls have fallen in the last two months. Looks like the sequence is pretty textbook stuff!

PM: Indeed, Princess. Unemployment is set to rise from its 4½% level, and before it hits 5%, as long as the ISM is hovering below 50, as I expect, the Fed will start easing. How’s that for getting specific?!?!  

MLF: Dangerous thing to do, Mac, probably too close to that thin line we were talking about earlier. But, your call, not mine, unless it’s right, in which it is ours. Remember, you’ve shorted me both a put and a call on your forecasts!! Meanwhile, what does it mean for the global economy and markets? And the almighty dollar, as people down south call it?  

PM: As long as the U.S. has a soft landing, the world will have a soft landing. Yes, America is the world’s consumer of last resort and yes, the rest of the world will feel soggier U.S. job, income and consumption growth, but it shouldn’t be a nasty spillover. The truth of the matter, Morgan, is that the U.S. is not the sole Keynesian engine of global aggregate demand growth. China is doing some pretty hefty Keynesian lifting, too, and both the developed and developing economies are piggy backing on that. So while complete global de-coupling from the U.S. slowdown is unlikely, the transmission mechanism is likely to have less traction than in the past. Thank goodness for China!  

MLF: Don’t hear many people saying that these days, Mac, especially from people who call themselves principled populists, as you do. Isn’t it still the case that the American worker is taking it on the chin from cheap Chinese labor, even as American consumers enjoy cheap Chinese goods? Doesn’t this imply that global imbalances and greater American income inequality are going to remain with us?  

PM: Indeed it does, Morgan. Free trade is a positive sum game, but that doesn’t mean that all win. It’s a net positive sum game, not a gross positive sum game. High priced, brute strength labor in the developed world is going to experience downward pressure on real wages for a long time to come. But protectionism isn’t the enlightened way to deal with that problem – and it is indeed a problem – but rather fiscal policy, both for retraining and income redistribution. The truth of the matter, Morgan, is that a flatter world, in Tom Friedman’s words, is also an un-flatter world when it comes to income and wealth distribution. It’s a problem that will be with us for a long, long time. And, regrettably, all I hear is lip service from Washington about dealing with it seriously with fiscal policy.  

MLF: Hold the phone here, partner, this publication is about global monetary policy, not global fiscal policy. Hear your point, but you need to stay on point. What does your Fed call mean for other central banks, and what does it mean for the dollar?

PM: I think it will be extremely difficult for other central banks to keep on tightening, once the Fed reverses to easing. Not impossible, but very unlikely I think, even where there is the visceral desire, especially in Japan. And the reason is that the almighty dollar is likely to become meaningfully less mighty, once the Fed starts to ease. And the reciprocal of a funkier dollar is pluckier non-dollar currencies. And while the rest of the world is less coupled to U.S. growth than it used to be, mercantilism is still the currency of the realm outside the United States, meaning nobody really wants to see their currencies go up much against the dollar, which they would if they kept tightening while the Fed was easing.

Always pays to remember, Morgan, former Treasury Secretary John Connally’s one liner, when the dollar was under pressure way back when: “the dollar is our currency, but a weak dollar is your problem.” Logical central bankers outside the United States will not want to exacerbate their problem of less competitive currencies by making them go up with tightening, while the Fed is easing.  

MLF: Okay, what about stocks? They going up as the dollar goes down?

PM: Yes, that is the most likely scenario: just remember what happened in 1995, the last time the Fed pulled off a soft landing – stocks soared, even with a soggy buck.  

MLF: ‘bout time to wrap this up, Mac. Let me summarize what we think, while noting that if it doesn’t come true, it is what you think, not me. Four simple points:  

The U.S. will experience a soft landing, as will the world, with the runway lubricated by Fed easing.
The U.S. yield curve will undergo bullish re-steepening, once the Fed gets on with easing.
The U.S. dollar is likely to be soggy, but not precipitously so, as the rest of the world doesn’t want to see their currencies soar versus the dollar, implying that monetary tightening outside the United
States is likely to draw to a close, once the Fed starts easing.
Stocks will do fine in the New Year.

Is that about right?

PM: Fair enough, Princess. Nice summary. Thanks for the chin wag and as was the case last year, let me give you the last words.  

MLF: Actually, let me close for the both of us, in the sprit of the season and as we did last year:

May God bless you and keep you, 
May God’s face shine upon you
and be gracious to you,
May God lift up his countenance upon you,
And give you peace.

               - The Priestly blessings 
                Numbers 6:22-27

Paul McCulley
Managing Director
December 27, 2006


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