U.S. economic expansions do not die of natural causes. The Federal Reserve either (1) properly executes them for the capital crime of insidiously-rising inflation; or (2) inadvertently manslaughters them with policy mistakes. Thus, without either insidiously-rising inflation or Fed policy mistakes, the current expansion will continue indefinitely.

Indeed, that is explicitly the Fed’s current goal. To be sure, policymakers always wisely cover their backsides by warning that “the business cycle has not been repealed,” presumably including recessions. But the whole notion of tightening to preempt cyclically-accelerating inflation, rather than reacting to it, is to make the expansion live forever: No inflationary crime, no recessionary time.

No argument from me about the Fed’s goal. A recession is the nastiest of regressive taxes and, as a principled populist, the notion of a “just” recession offends me. Thus, I’m as hawkish as they come about the need for the Fed to preempt insidiously-rising inflation that might “justify” a recession. At the same time, I’m as dovish as they come about the need for the Fed to respect wage earners’ Fifth Amendment rights to a presumption of inflationary innocence.

At the November 16th Federal Open Market Committee (FOMC) meeting, the Fed stopped short of outright convicting wage-earners for the crime of generating inflation. But the FOMC did indict labor for the crime of getting too many jobs, hiking both the Fed funds and discount rates by 25 basis points, and declaring:

“…the pool of available workers willing to take jobs has been drawn down further in recent months, a trend that must eventually be contained if inflationary imbalances are to remain in check and economic expansion continue.” 

Fed Tightens: Stock Rejoice?
   Figure 1 is a line graph showing the relative performance of the Nasdaq, S&P 500 and long U.S. Treasury bond futures from 15 November 1999 to 5 December 1999. Each index begins at a baseline of 1 on 15 November. (The U.S. Federal Reserve increased the fed funds rate by 25 basis points on 16 November.) The Nasdaq increases the most over the period, to almost 1.1 by December 5. The S&P’s performance is relatively flat, increasing to about 1.03. Long bond futures declines to 0.96 over that time frame.
Figure 1
Source: Bloomberg


Treasuries and Stocks Part Company

The U.S. Treasury market has been in a funk ever since, while the U.S. equity market has rallied merrily, as shown in Figure 1. At first blush, the implicit message of this divergence between Treasuries and stocks is that the Fed is “doing the right thing” in declaring war on rapid job creation.

Treasuries sell off because their coupons are fixed, and must be valued relative to a higher expected path for short rates. Stocks rally, however, because their earnings are variable, and they will be higher for longer, if the Fed “successfully” prevents a labor-cost-driven erosion in corporate profit margins and/or an acceleration in price inflation.

That’s the argument of those buying stocks anyway and, in real time, perception is reality. As we look to the New Millennium, however, we must ask if stocks are discounting a rational economic scenario. At the risk of being accused of arrogance, hubris, or both, I think not.

While equity earnings can indeed grow while Treasury coupons are fixed, Treasury yields are still the valuation benchmark for all earnings streams. Thus, stocks are worth more in a rising Treasury yield environment only if (1) earnings are expected to rise even faster than Treasury yields, and/or (2) the risk premium is expected to fall. Without either one or both of those expectations, a bear market in Treasuries implies either a bear market in stocks, or a stock market bubble.

Old Model In A New World

I believe it is wrong for the Fed to automatically presume that tight labor markets and rising wages tautologically imply accelerating price inflation. Implicit in such a presumption is the notion that labor markets and tangible capital markets are tightening simultaneously.

Historically, that has indeed been the case, as the unemployment rate for labor and the idle rate for tangible capital (the inverse of the capacity utilization rate) have moved together, as vividly displayed in Figure 2. In that configuration, labor and capital simultaneously garner pricing power, which gives birth to a cost-plus model of price inflation: Labor is tight and demands accelerating wages, but capital is also tight, and can thus “pass through” accelerating wages into prices.  

It's A Brave New World: Tight Labor Markets,
But Loose Tangible Capital Markets
   Figure 2 is a line graph showing U.S. idle capacity versus the unemployment rate, from 1968 to 1999. The two metrics roughly track each other over the period, but start to diverge around 1995. Idle capacity rose to about 19% in 2000, up from around 17% in 1997 and 15% in 1995. Over the same period, the unemployment rate, fell to about 4%, down from around 5.5% in 1995. Over the entire time span, both metrics show similar peaks and troughs before 1995. For example, they peaked around 1971, 1975 and 1983, and bottomed in 1970, 1974, 1981 and 1989.

Figure 2
Source: Bloomberg

The FOMC is explicitly using such a cost-plus inflation model when it declares that robust job creation threatens “inflationary imbalances.” The problem is that the facts don’t currently fit the model! While the labor market has unambiguously tightened in recent years, the tangible capital market has not, as a result of a boom in capital investment.

This “capital deepening” process, with each unit of labor endowed with ever more units of technologically-advanced capital, has turbo-charged productivity growth. As a consequence, and for the first time in over a generation, labor’s share of GDP has risen relative to capital’s share of GDP, in the context of falling core inflation, as vividly displayed in Figure 3.

Thus, I take major exception to the FOMC’s declaration that the shrinking “pool of available workers” is an inflationary problem in the making. If there is a problem in the making, I submit it is deflationary pressure on corporate profit margins! Indeed, that is precisely what the microeconomics of the situation would dictate: If there is a shortage of labor relative to capital, then the return to labor should rise relative to the return to capital. The Fed has declared, however, that it will not tolerate such an outcome.

Labor's Piece Of The Pie Rises
Without Rising Inflation
   Figure 3 is a line graph showing U.S. wages versus inflation (measured by U.S. core Consumer Price Index) from 1968 to 1999. Wages are expressed as the ratio of wage share to profit share of U.S. gross domestic product. The metric increased to about 4.8% by mid-1999, up from about 4.3% in 1997, but it’s still at the low end of its range of the chart. Core CPI inflation fell to less than 2% over the same period, down from about 2.3%, and is at its lowest level on the graph as of 1999. Since the early 1980s, both metrics have trended downward. Wage to profit share of GDP is around 8% in 1982, while core inflation is around 13% in 1980.
Figure 3
Source: Bureau of Economic Analysis, U.S. Commerce Department

Moral Hazard Infects Equities

The equity market is betting that the Fed will be “successful” in overturning the microeconomic laws of relative scarcity and price determination. The equity market is also betting that the Fed will be able to accomplish that mission with only limited further rate hikes, thereby inoculating stocks from the downward valuation pressure that is so evident in Treasuries. Put simply, the equity market is enthusiastically embracing a “soft-landing.”

I submit that the equity market’s bullish embrace of a “soft-landing” actually makes one less likely, because the wealth created by rising stocks stimulates aggregate demand. Put differently, every time the equity market “celebrates” Fed tightening, the act of celebration makes it more likely that the Fed will tighten again. I would like to believe that the Fed recognizes this phenomenon but, so far, it has shown no evidence to that effect.

Fed policymakers, including Chairman Greenspan, muse about the undesirable wealth effect from rising stocks. At the same time, they refuse to declare stocks to be overvalued, as if such a declaration would be an abomination against capitalism (even though policymakers have no problem declaring Treasuries to be overvalued, as they do every time they adopt a bias to tighten).

What is more, Fed policymakers, again including Fed Chairman Greenspan, openly acknowledge that if stocks, for whatever reason plummet, they will ease. Overall, then, the Fed refuses to “cut off” the upside for stocks, but volunteers that it will underwrite the downside. This configuration has moral hazard written all over it and, as a consequence, a yet larger stock market bubble. And, while inflating, a bubble stimulates aggregate demand, portending ever-tighter monetary policy, if the Fed is serious about keeping the reserve army of the unemployed (sorry, “the pool of available workers”) from shrinking further.

Hard-Landing Risk

As I look to the New Millennium, I see a rising risk of a “hard-landing” scenario, even as the equity market is pricing in a “soft-landing” scenario with ever-greater enthusiasm. The culprit is the Fed, which has (1) declared war on a rising return to labor relative to capital, when the microeconomics of the matter imply precisely that outcome; but (2) refused to declare stocks to be overvalued, thereby underwriting moral hazard-driven appreciation in stocks.

In the short run, such a policy course implies both rising interest rates and rising stocks, but in the longer run, such a policy course implies a stock market crash, a precipitous (and deflationary) deceleration in economic activity, and a new bull market in Treasuries. I want to stress that I don’t think that’s what should happen, but on the Fed’s current policy course, I increasingly believe that’s what will happen.

In contrast to others, however, I don’t think the Fed should tighten with an explicit declaration of war on stocks, though I admit that would be preferable to the Fed’s current course. No, what the Fed, notably Chairman Greenspan, should do is declare the stock market to be overvalued, simply and plainly. The easiest way to do that, I repeat once again, would be for the Fed to hike margin requirement on stocks.

Fed officials variously fret, of course, that such a step would either not work, or work too well. I regrettably have to conclude that they actually think it might work too well, driving stocks sharply lower, and that they would be blamed for the damage. So, the nattering nabobs of NAIRU declare war on job creation instead.

As I stated at the outset, U.S. expansions do not die of natural causes: The Fed either executes them, or manslaughters them. Since this expansion is not committing the capital crime of insidious inflation, there is no reason for the Fed to execute it. But I must regretfully conclude that the Fed’s declaration of war on job creation, rather than stock speculation, carries a rising risk of bringing this expansion to a tragic end. I wish it weren’t so, but wishing is a poor substitute for logic.

The outlook is turning a ghostly whiter shade of pale.

Paul A. McCulley
Executive Vice President
December 6, 1999







No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission.
This article contains the current opinions of the author but not necessarily Pacific Investment Management Company, and does not represent a recommendation of any particular security, strategy or investment product. 
The author's opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
This article is distributed for educational purposes and should not be considered as investment advice or an offer of any security for sale. Past performance is not indicative of future results and no representation is made that the stated results will be replicated. Copyright ©1999-2003 Pacific Investment Management Company LLC. All rights reserved.