Over the last year, monetary policy makers and market practitioners have spent a huge amount of mental energy, loads of computer time and gallons of ink examining the conundrum – the putatively too-low level of long-term real interest rates, both absolutely and relative to real short-term interest rates. We’ve certainly done so here at PIMCO, and our empirical findings mirror those of others, including new Fed Chairman Bernanke, making the conundrum the subject of a major speech, even before he chaired his first FOMC meeting. ¹

And the key finding is that there is no single finding, but rather a family of suspects:

• An excess of global savings relative to ex-U.S. desired investment, which begets huge foreign savings flows – both private and official – into the U.S., the mirror image of America’s current account deficit, which has reduced the equilibrium real long-term rate.
  
  
• Well-anchored long-term expectations of low inflation, and a reduction in economic volatility (more generally known as the Great Moderation), which has reduced the risk premium for both inflation and future real rate volatility.
  
  
• A move to liability-driven investment strategies by pension funds with long duration liabilities, in the context of a shortening of the average maturity of the Treasury’s stock of debt.
  
  
• Increased transparency of central banks ‘round the globe, which has reduced the risk premium for policy uncertainty.

As an empirical matter, it is difficult to parse the precise impact of each of these suspects, though that does not seem a deterrent to the cottage industry engaged in torturing the data in search of confessions. And, in fact, I’m not sure these four suspects necessarily committed the conundrum crime. They may have simply been at the scene of the crime!

Moral Hazard
In which case, who dunnit? ‘Twas the oldest of villains named moral hazard, the bootlegger behind nearly all skinny risk premium crimes. And, in fact, there were three of them: the Peoples Bank of China (PBOC), the Bank of Japan (BOJ) and the Federal Reserve.

Not that they did anything illegal, I hasten to add. Rather, for their own individual good reasons, they precommitted to absorbing three major risks from the global markets: ·           Stretching back to 1995, PBOC precommitted to absorbing dollar depreciation risk via a pegged exchange rate regime for the Renminbi.

• Starting in February 2001, the BOJ precommitted to absorbing Japanese short-term interest rate risk via its Zero Interest Rate Policy (ZIRP), reinforced by its Quantitative Easing (QE) policy.
  
  
• Starting in August 2003, the Fed precommitted to holding short rates accommodative for a “considerable period,” followed by a precommitment to remove such accommodation in only a “measured” fashion.

Each central bank rationally entered into its precommitment, for sound domestic reasons. In China’s case, the rationale was to “import” a nominal anchor for its own monetary policy, consistent with its mercantilistic growth strategy. In Japan’s case, the rationale was to reflate from the deflationary swamp. And in America’s case, the rationale was to cut off the fat-tail risk of debt deflation.

In all three cases, the central banks were acting as insurance agents, underwriting risks that the global markets would otherwise have had to absorb and price. This is called moral hazard, similar to that of deposit insurance, which frees depositors from having to absorb and price the risk of their depository going belly up. To be sure, these three precommitments were not as explicit or as robust as deposit insurance. But they were explicitly cut from the same bolt of moral hazard cloth, in all three cases as intended inducements to more risk seeking behavior by private sector agents.

Reflexive Is As Reflexive Does
It was fun, as always is the case in the beginning of moral hazard-driven schemes: with policy makers removing sources of volatility risk from markets, actual volatility falls, which like gravity, pulls risk premiums – the market compensation for underwriting volatility – lower. More specifically, P/Es rise, term premiums narrow, credit spreads tighten, and implied volatilities in options fall.

As this process unfolds, the forward-looking return on risky assets falls, but their real time actual return is heady, as lower risk premiums are capitalized. This is a perfect prescription for bubbles, per Soros’ reflexive principle: momentum-driven investors, mesmerized by trailing returns, increase their buying as valuations rise, which definitionally reduces prospective returns.

Such has been the case in recent years, with global markets riding on the wings of the big three central banks’ precommitments to absorb volatility risks. Debate as to whether the big three should have done what they did frequently takes on a religious character, with Keynesians applauding and Austrians booing. You know which camp I’m in! But regardless of your religious persuasion in these matters, we should all agree on what transpired: concerted global reflationary monetary policy, with central banks de facto shorting both a deflationary put at the bottom of their inflation comfort zones and an inflationary call at the top of those comfort zones. ²

The put has gone way, way out of the money. This should be no surprise, as Fed Chairman Bernanke famously declared in November 2002:

“The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. A little parable may prove useful: Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject’s oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.

What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”

And so the case has been, even in Japan: determined governments, under a paper-money system, can always short deflation protection to the markets. They can sell that put, however, only if they simultaneously sell an out-of-the-money call on inflation. Which, of course, central banks don’t like doing, because it might just go into the money, presumably the top of inflation comfort zones.

Such has been the worry of the Fed over the last year, and to a lesser degree, the worry of BOJ, PBOC and the European Central Bank (ECB). To be sure, their concerns haven’t been exactly the same, with the Fed focused primarily on inflation risks in goods and services prices, while the other big three central banks put more focus on inflation risks in asset prices. But both of those risks have the same origin: the out-of-the-money call on inflation that central banks shorted when they gifted the markets with deflation protection. And now, all four of the central banks want to cover that short, returning policy rates to neutral-to-restrictive zones. Call it moral hazard interruptus.

And call global financial players annoyed. It was a great gig while it was going on, but now, the global financial markets must reabsorb risk – most notably the risk of volatility in the exchange value of the dollar and the risk of volatility in global short rates. To be sure, the Fed is either finished tightening, or nearly finished. But the BOJ hasn’t even started yet, except to end QE; the end of ZIRP and what happens thereafter is a genuine source of risk that the markets haven’t had to bear in a long time.

The same holds for the dollar-renminbi exchange rate, even though it has fallen only about 3% since last summer, when the PBOC shifted from a currency peg to a tightly, very tightly managed float. While the PBOC would no doubt like to continue moving at a snail’s pace toward greater flexibility, it is an open question as to how long America will tolerate that, resisting protectionist impulses.

Bottom Line
The great Hyman
Minsky famously declared that stability is de-stabilizing. The experience of recent years reinforces the truth of that proposition, particularly when stability is bought with moral hazard. A little moral hazard is, to be sure, a necessary lubricant for global capitalism. And a little more than a little is the only path to cutting off fat-tailed deflationary risks. But way too much is not, in the words of Mae West, just about right.

Accordingly, the world’s central banks, all at the same time for the first time in this cycle, are withdrawing their precommitments to absorb volatility risks. It should come as zero surprise that the global markets are becoming more volatile, with risky asset prices falling, so as to restore their risk premiums, including the term risk premium in the slope of the yield curve. Reflexive is as reflexive does, in the words of another great economist, Forrest Gump.

And, ironically, the more pain that the markets suffer as they reabsorb risk, the more patient central banks can be in withdrawing moral hazard, as tightening global financial conditions are, ultimately, disinflationary. The really tricky monetary maneuver for central banks will be to intellectually embrace this truism, ignoring accusations that retrenching markets are somehow calling into question their anti-inflation credibility.

They are not. Rather, markets are re-pricing themselves for the withdrawal of moral hazard, a most credible anti-inflation central bank maneuver.

Paul McCulley
Managing Director
May 22, 2006
mcculley@pimco.com

¹http://www.federalreserve.gov/boarddocs/speeches/2006/20060320/default.htm
²Special thanks to my colleague, Vineer Bhansali, for pushing me to think in these terms.