n Introduction by Bill Gross

Get ready for everything you wanted to know about the Fed but were afraid to ask. This month, PIMCO initiates our “PIMCO Fed Focus” authored by Paul McCulley who heads up our short-term desk and who was recently wooed back to our hallowed halls from Warburg Dillon Read, where he served as Chief Economist for the Americas.

Paul’s knowledge of the Fed was legend here at PIMCO during his first tenure in the early 90’s and we’re glad to have him back. I think you’ll enjoy his fresh and personal writing style. He promises to be concise as well, recognizing you only have so many minutes in a day. Paul’s “Fed Focus” will appear at the beginning of each month and my “Investment Outlook” will continue to hit the press around mid-month. Enjoy!

Bill Gross

George W. Bush is running on a platform of “compassionate conservatism.” I’ve struggled, as both an economist and a financial market participant, to figure out exactly what this means. “Conservatism” normally means a strong belief in unfettered markets to produce “optimal” economic results, notably the most efficient possible distribution of economic resources, via Adam Smith’s “invisible hand.” Call it capitalism.

In this stylized “conservative” version of economic life, governmental intervention into markets is not only not necessary but also harmful, because it “distorts” the clarion allocative message of unfettered market-driven price changes. There is no room for “compassion” in this model. Markets are assumed to “know best.”

As a practical matter, of course, the U.S. economy has never been structured along a “pure” capitalist model. It is a mixed economy, with markets carrying the heavy load in allocating resources, but in the context of government-imposed rules.

For example, we do not allow prices to determine the demand and supply of child labor; we simply prohibit demand. Likewise, we do not allow prices to determine the demand and supply of narcotics; we try to prohibit supply.

Most Americans support the notion that sometimes it can be appropriate for the government to substitute the people’s collective judgment on what is right and wrong, for outcomes that the people, driven purely by market price signals, would otherwise generate.

The bone of political contention is not whether government intervention into markets is sometimes appropriate, but when and where it is appropriate. In fact, the zone of political disagreement has shrunk over the last decade, perhaps best demonstrated by bi-partisan support for welfare reform with a safety net, which could be called either “conservative liberalism” or “liberal conservatism.”


Corporate Stocks Are Rich And
Corporate Bonds Are Cheap
   Figure 1 is a line graph showing two metrics: the spread of the S&P 500 earnings yield to the 10-year U.S. Treasury yield, and the spread of A-rated bank yield to 10-year U.S. Treasury yield. The time period is from October 1991 to February 1999. In early 1999, both spreads are trading outside of their standard deviations. The spread of equity yields to those of Treasuries is around negative 300 basis points, well below its historical average of 178 and more than one standard deviation below it. Spreads of bank yields over those of Treasuries in early 1999 are around 140, near their highest level on the chart, and well above one standard deviation from their historical average of 77.
Figure 1
Source: Bloomberg

No Paradigm

Regrettably, a similar intellectual consensus has not emerged with respect to Federal Reserve policy, even though there is widespread support for current Federal Reserve policy and in particular for Fed Chairman Greenspan. Current results are deemed fine, and therefore, the Fed is deemed to be doing a fine job.

There is, however, no commonly understood or commonly accepted paradigm for the conduct of monetary policy, except perhaps “we trust in Greenspan.” This vacuum in both policy formulation and articulation need not be, and should not be.

By definition, the Federal Reserve is the most powerful force of governmental intervention in the “mixed” U.S. economy. It has monopoly control over short-term U.S. interest rates. Fed policy is conducted, to be sure, in the context of “free” capital markets, and many argue that the Fed simply listens to the markets in exercising its fiat control over short-term interest rates.

I submit, however, that the opposite is true. Market prices for bonds, stocks and the U.S. currency are not a statement about what the Fed “should do,” but rather a probabilistic statement about what the Fed “will do.” Markets are not price setters, but price takers, with the price maker being the Fed.

There is, of course, an issue of circularity here, as both markets and the Fed are looking at the same “economic fundamentals.” Thus, when markets move in anticipation of a change in monetary policy, they are making a statement not just about what the Fed “will do,” but about what the Fed “should do.”

But there should be no mistake about who the straw is that stirs this drink. The Fed owns a liquidity-creation machine, while the markets are only liquidity-reallocation machines.

Thus, the markets’ collective demand for liquidity must ultimately adjust to the Fed’s supply of liquidity, not the other way around. Indeed, the notion that “inflation is always and everywhere a monetary phenomenon” is predicated on the notion that (1) the central bank has monopoly control over the creation of liquidity and that (2) in the long run, inflation cannot exist, unless the central bank supplies sufficient liquidity to accommodate it.

This notion is actually nothing more than a tautology, borne of the Fed’s monopoly control over liquidity creation. It tells us nothing, per se, about how the Fed should conduct monetary policy.

To be sure, there is widespread consensus around the joint proposition that (1) long-run macroeconomic price stability is the best environment for markets, via the invisible hand, to produce optimal economic resource allocation and that, therefore (2) the Fed’s dominant goal should be achieving long-run macroeconomic price stability.  

No Roadmap

These articles of secular economic faith do not, however, provide a roadmap for the real-time conduct of monetary policy. More specifically, these articles of faith do not, as current intellectual consensus holds them, provide justification for (1) monetary actions to preemptively eliminate the cyclicality of inflation, and/or (2) the exclusive use of preemptive short rate hikes as the Fed's only tool.

That is not to say that there is no place for preemptive short rate hikes. There most certainly is. But it is the height of hypocrisy for the economics community, which strenuously argues that the business cycle has not been repealed, to simultaneously argue that the Fed’s secular anti-inflation credibility should be measured by whether it “flat-lines” inflation on a cyclical basis. The very notion smells of the hubris of central planning. Cyclical increases in inflation are not always, everywhere, and at all times evil.

This is especially the case once the promised land of secular price stability has been reached. At that point, which the Fed has arguably achieved, the notion of “opportunistic cyclical disinflation” becomes an oxymoron, giving way to the risk of “in-opportunistic secular deflation.”

Time For Change

Accordingly, the Fed’s cyclical calculus must change: The risk of a cyclical shortfall in aggregate demand becomes as dangerous as the risk of a cyclical increase in inflation. And since the Fed is not only custodian of the U.S. business cycle but also custodian of the global reserve currency, the Fed’s calculus must consider not only the domestic, but also the international consequences of “in-opportunistic deflation.”

Now is such a time, in my view, for two reasons: 

 (1) The U.S. stock and corporate bond markets are in valuation “misalignment,” with the equity risk premium too thin and the credit risk premium too wide. As displayed in Figure 1 on the cover, stock valuation is almost two standard deviations rich to its mean over the last decade, while corporate bond valuation (proxied by bank bond valuation, the foundation of the swap market, which is the foundation for high-grade credit spreads) is over two standard deviations cheap to its mean over the last decade. The key reason for this “misalignment,” in my view, is the differential impact of the threat of preemptive Fed rate hikes.

For stocks, preemptive Fed rate hikes are tolerable “tough love,” as long as they don’t threaten recession. For corporate bonds, however, preemptive Fed rate hikes carry the perpetual threat of a liquidity crisis, even if they don't imply recession. Thus, stocks are valued on the notion that the Fed has no justification to provoke a recession to fight actual inflation, while corporate bonds are valued on the notion that the Fed might justify inducing a liquidity crisis to preempt expected inflation.

In a nutshell, corporate stocks are rich relative to corporate bonds, because stocks have perpetual maturity, while corporate bonds carry rollover, or liquidity risk. The same analysis holds for emerging market bonds, where rollover risk is even more extreme.

(2) The U.S. economy is in the midst of a positive secular shock to aggregate supply, borne of technology. This development provides more secular “room” to grow, and implies that the Fed should accommodate a secular increase in effective demand, so as to thwart secular deflationary pressures, even at the risk of a cyclical increase in inflation.

In fact, the greatest cyclical upside threat to inflation would, ironically, be a Fed-tightening induced slowdown in aggregate demand, which would ineluctably bring a rapid slowdown in productivity growth, and a sharp acceleration in unit labor costs. Such a policy course would provoke a self-justifying bout of stagflation, as Figures 2 and 3 below vividly display.


As Goes Demand, So Goes Productivity...
   Figure 2 is a line graph showing U.S. nonfarm productivity and final sales to domestic purchasers, from 1980 to 1999. Both metrics roughly track each other over the period. Nonfarm productivity, scaled on the left-hand axis as a percent change from a year ago, is around 2.75% in 1999, up from about negative 0.5% in 1993. Final sales, scaled on the right-hand side, are at 5%, up from negative 2% in 1990. Nonfarm productivity tends to lead final sales, and it has turned downward slightly in 1999, falling from about 3% to 2.75%.
Figure 2
Source: U.S. Bureau of Labor Statistics and U.S. Bureau of Economic Analysis

...Taking Unit Labor Costs And Inflation
In The Opposite Direction
   Figure 3 is a line graph showing U.S. unit labor costs, final sales to domestic purchasers, and core inflation (as measured by the Consumer Price Index or CPI), from 1980 to 1999. In 1999, unit labor costs, as a percent change from a year ago, are a little less than 2%, a level at which it fluctuates around since 1992. Labor costs had spiked in 1991 to about 7%, but then fall to the 2% range after that. Core CPI falls to about 0% by 1999, down from its last peak of around 6% in 1991. Final sales to domestic purchasers, shown as a percent change from a year ago, rise to 5% by 1999, up from their most recent major low of around negative 2% around 1991.
Figure 3
Source: U.S. Bureau of Labor Statistics and U.S. Bureau of Economic Analysis


A New Agenda

A far better Fed agenda, in my view, would be that of “principled populism.” Such an agenda would, as in the “conservative” variety, start with the principle that the Fed’s key long-term objective is macroeconomic price stability.

At the same time, an agenda of principled populism would require that the Fed intellectually accept, as compassionate conservatives ostensibly do, that market mechanisms operating solely on price signals do not everywhere and always produce optimal societal outcomes.

More to the point, principled populists would accept the proposition that the perpetual threat of short rate hikes is a de-stabilizing influence in its own right: It breeds chronic illiquidity in credit markets, which is succor for stock speculators, since they “know” the Fed must ease if, and more likely when, chronic illiquidity in credit markets becomes acute.

By elevating stocks in the Fed’s “cyclical reaction function,” as Mr. Greenspan unequivocally did two weekends ago at Jackson Hole, he has paradoxically produced a yet stronger “greater fool” rationale for buying stocks. The Fed has laid down a threat that it doesn’t have the flexibility to enforce.

Mr. Greenspan would, no doubt, disagree with this proposition, arguing as Fed Governor Kelly did last week, that the Fed is not “targeting” stocks per se, but merely increasing the emphasis it places on stocks in the mosaic of factors generating “excessive” (read, cyclically inflationary) growth in aggregate demand. But Mr. Greenspan would be wrong in making such an argument.

By definition, a monopolist cannot change the weights it puts on the variables it is observing, without changing the nature of those variables. In physics, this phenomenon is known as “hysteresis.” In central banking, and in the context of stocks, it is, or should be, known as “moral hazard.”

By example, the Fed effectively declared, as an angered parent, that a clean room is a necessary condition for the payment of school tuition, even though the child “knows” that in the end, the tuition will be paid.

“Bad move, Pops,” my 10-year-old son would say. And he would be right!

Targeted Dicipline

If the wealth effect of rich stock market valuations on aggregate demand is deemed inflationary, then monetary policy should be aimed directly at thwarting stock appreciation, without (1) simultaneously bankrupting borrowers who are not speculating in stocks, or (2) inducing layoffs of recent entrants into the labor force, whose only “sin” has been to become productively employed, many for the first time.

Rather than threatening perpetual rate hikes, the Fed will, if it is serious about thwarting “inflationary” appreciation in stocks, complement rate hikes with its regulatory powers to impose quantity restrictions on credit creation. Or, as in dealing with my son’s perpetually messy room, it will simply cut off liquidity for the purchase of Pokeman cards, I mean stocks.

The most obvious tool available to the Fed in “fighting” irrational exuberance in stocks is margin requirements for borrowing against stocks; they should be hiked, aggressively. Less obvious tools, though probably even more powerful, are risk-based capital guidelines and loan quality examination standards for banks; both should be hiked, aggressively.

The bottom-line: monetary discipline, which is good for us, like parental discipline, must be both credible and enforceable. Otherwise, it is a prescription for proliferation of spoiled brats, both on the floor of the New York Stock Exchange, and at home. 


Public Support Matters

Principled populism need not be soft on inflation, just like compassionate conservatism need not be soft on capitalism. Public support for both price stability and a market-driven economy requires that the public believe that the policy makers will act to prevent arbitrary and capricious outcomes.

After all, democracy is grounded on the principle that one person gets one vote, while capitalism is a cumulative voting process, where one dollar gets one vote. Democracy is inherently biased to Robin Hood outcomes, while capitalism is inherently biased toward reverse-Robin Hood outcomes.

Democracy and capitalism are therefore inherently in conflict, which is why monetary authorities are given operational independence from the democratic process - to protect our democratic selves from our inflationary selves.

But while the central bank may be independent within the government, it is not independent of the government. The public simply does not buy the notion that full employment in the context of price stability (and a federal budget surplus!) is a “problem” to be preemptively “solved” by a nasty independent central bank. I don’t either.

Investment Implications

I believe Mr. Greenspan understands this policy exigency very well, and has practiced it in recent years, over the objections of his strict “conservative” colleagues. I expect Mr. Greenspan to continue such a course.

I further expect that in the fullness of time, this course will morph more formally into principled populism, with Mr. Greenspan publicly acknowledging that he needs to use the full range of tools at his disposal, including most importantly, non-price restrictions on speculative credit creation, notably in the equity (and property) arena.

If I’m right on that, the investment implication is clear. Stocks should be sold into high-grade credit instruments. If I’m wrong, however, and the Fed insists on sole reliance on preemptive rate hikes until aggregate demand cries uncle, the investment implications are also (regrettably) clear. Stocks and credit instruments should be sold into cash and long Treasury strips.

Perhaps Mr. Bush should have a conversation with Mr. Greenspan about the imperative of principled populism at the Fed. Without it, “compassionate conservatism” will mean nothing more than bailing out the victims of an unnecessary, deflationary recession.

Paul McCulley
Executive Vice President
September 7, 1999







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