We believe in risk management at PIMCO. Indeed, we breathe risk management at PIMCO. Risk management is not, however, the wind beneath our wings. Rather, risk management is a complementary paradigm to our core mission: outperforming client-chosen benchmarks, with limited volatility relative to those benchmarks, while following clients’ guidelines. Or, in the jargon of the business, we aim to add alpha with minimum tracking error, thereby delivering a high information ratio. That’s our business. And it starts with an investment philosophy and process: a view as to how the economic and financial world works, in both secular time (3-5 years) and cyclical time (6-12 months).

On a secular horizon, our key concern is the power struggle between (1) capitalism, founded on the principle of one dollar (monetary unit), one vote; and (2) democracy, founded on the principle of one person, one vote. Or, if you prefer, the key secular issue for us is the power of the invisible hand of (global) markets versus the power of the visible fist of government (which globally may or may not be democratically determined). Will capitalist markets, the engine of creative destruction through competition, prevail; or will government interference in markets thwart the Darwinian process of capitalism? This is the big picture question we ask every May at our Secular Forum , and right after, Bill Gross details to you, our clients, what we think and why we think it. Call it transparency.

The figure is a line graph showing the forward expectations of three-month LIBOR (the London Interbank Offered Rate, a common benchmark for short-term investments) on nine different dates, with those expectations charted from November 2002 to about mid-year 2005. Realized historical LIBOR is also shown from January through October 2002. Each date marks a significant event, and is represented by a line of forward LIBOR expectations on the graph. Most of the trajectories resemble a hockey stick, first declining from a peak of just above 2.00 then decline to a trough before rising after that. Seven of the lines bottom between roughly mid-year 2003 and late 2003. The highest line, representing 21 November 2002, when Bernanke speaks, shows that expectations for three-month LIBOR reaching 3.50 by the third quarter of 2004. The date of 03 June 2003, a day when Greenspan speaks, shows the lowest expectations, with LIBOR bottoming around 1.00 in October of 2003, and only rising to about 1.80 by the second quarter of 2005. A line marking “today” (September 2003) shows much higher expectations—and a higher line—with LIBOR reaching about 3.90 by around mid-2005, a level that’s higher than shown on any of the other lines.

On a cyclical horizon, our key concerns are the traditional macroeconomic variables of growth and inflation, in the context of our secular view. Examining these variables, as we do quarterly at our Cyclical Economic Forum , ineluctably involves analyzing macroeconomic policies, notably monetary policy, which as Milton Friedman intoned long ago, works with “long and variable lags.” The key cyclical issues for us are:

  • The level of domestic and global employment relative to “full” employment (output “gaps”), and the likely course for unemployment;

  • The level of domestic and global inflation relative to central banks’ explicit and implicit “targets” (inflation “gaps”), and the likely course for inflation;

  • The state of risk appetite (Keynes’ “animal spirits”!) on both Main Street and Wall Street, and the likely course for risk appetite; and

  • The prevailing array of consensus investor expectations about all these things, as embedded in asset prices, notably the expected path for central bank-controlled interest rates.

In the current context, which we will be examining this Friday at the Cyclical Economic Forum , the key issues for us are:

  • The timing of the handoff of growth leadership from the household sector to the business sector, and

  • The nature of the Fed’s response, in the context of victory in the Fed’s secular war against inflation and a new secular campaign to win the peace of “price stability.”

PIMCO’s account managers prepare detailed written reports on what we cyclically think and why we think it, and meet extensively with you, our clients, delivering both formal and informal presentations, at both the committee and board level. Call it transparency.

PIMCO’s Investment Committee , chaired by Bill, takes all this macroeconomic analysis, both secular and cyclical, into its thinking, and develops and promulgates model portfolios, setting the roadmap for all PIMCO portfolios, with targeted levels and variances for at least five key risk measures – on a global basis! – relative to benchmarks: (1) duration, (2) yield curve, (3) credit, (4) volatility, and (5) non-benchmark sector allocations.

These top-down missions completed, PIMCO’s portfolio managers go to work getting all our portfolios in line with the model portfolios, exploiting the best bottom-up ideas of both our generalists and specialists. Throughout this process, we work with state-of-the-art quantitative risk measurement tools, under the watchful eye of PIMCO’s Guru of Risk, Pasi Hamalainen, working in tandem with PIMCO’s Chief Financial Engineer, Vineer Bhansali, and his band of propeller-hatted rocket scientists.

And when we are finished, we tell you, our clients, what we are doing with your portfolios. We fully expect you to hold us accountable to do what we say, with PIMCO’s account managers, led by the redoubtable Bill Benz and Brent Holden. They watch everything we do, acting as the critical link between PIMCO’s trading room and you, PIMCO’s client, making sure that we are serving you, not ourselves. Call it transparency.

But nowhere could you say this process breeds inflexibility. Our philosophy and our process are ever evolving, as are our views, and the construction of your portfolios. Borrowing a phrase from Fed Governor Ben Bernanke, what we do here at PIMCO is actively manage portfolios with “constrained discretion.” You, our clients, pay us to exercise our best judgment. There is no sin in changing our minds; indeed, it is a sin not to change our minds, if and when the facts change (as Lord Keynes intoned long ago). That said, you, our clients, fully expect us to explain if and when we change our minds, and to detail how our changed minds are reflected in changes in your portfolios. Call it transparency.

We practice transparency, not just because you demand it, but also because “constrained discretion” is the essence of prudent active portfolio management. It’s about you, our clients, keeping us honest. But even more fundamentally, “constrained discretion” is about keeping our investment philosophy and process honest: knowing our business and being willing to explain what we are doing, why we are doing it, all in the context of rigorous risk management.

Am I bragging on behalf of PIMCO? Sure, but only as a point of departure to discussing Federal Reserve policy. If it is good policy for PIMCO to operate within a paradigm of “constrained discretion”, with full transparency, why would it not be good policy for the Fed to operate with a similar paradigm?

In Greenspan We Must Trust?
Fed Chairman Greenspan has long cherished his job, and quite naturally so. He is, after all, the chief steward of a monopoly that “we the people” grant by law: the power to print money. At one time or another, we’ve all mused about how much fun it would be to have a printing press in the cellar that could print up some dead presidents, whenever we needed them. It would be cool, no doubt. It would also be illegal.

Only the Federal Reserve is allowed to print money, stuff called Federal Reserve Notes, which are “ legal tender for all debts, public and private.” Yes, that’s what it says on the folding green in your pocket; pull out a sheet and take a read, if you don’t believe me. It is money, because the law says it is; and if you’ve got it, those to whom you owe money must take it in the extinguishment of your debts. No wonder it’s illegal for us citizens to have a printing press in the cellar. Who could resist abusing the thing?!?! Including our democratically-elected leaders, of course, from both the legislative and executive branches.

Money is too dangerous to be left to popularly-elected politicians, who would naturally (not cravenly!) be tempted to use the printing press to cover the gap between politically-inspired promises (to spend more, or to tax less) and the ability of the economy to deliver in a non-inflationary way. Out of this milieu was born the idea of an operationally-independent central bank, politically legitimized by and accountable to laws passed by a democratically-elected legislature, but once so established, accorded operational autonomy to conduct monetary policy in a professional, non-political way.

Such has been the case with the Federal Reserve since the Accord of 1951, when the Fed “negotiated” its independence from serving as a buyer of last resort for the Treasury’s (WW II-driven) issuance of debt at capped interest rates. And since the passage of the Full Employment and Balanced Growth Act of 1978 (commonly known as the Humphrey Hawkins Act), the Fed’s operational autonomy has been under an enabling umbrella directing the Fed “t o promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

To me, that sounds like the beginning of a discussion with a prospective PIMCO client about a set of guidelines and a benchmark for an active management assignment! Note, I said the “beginning” of a discussion, not the sum total of the discussion. If PIMCO’s Investment Committee were given the (intellectual only!) challenge of carrying out the Fed’s legislated mandate, the first thing we would ask would be: How do you define “ maximum, stable and moderate?

We would want to know what those adjectives mean, so that we could establish a benchmark for performance. We would also want to know the relative weights that we should put on the three objectives, on both a static and dynamic basis. Put differently, we would want to know the accepted deviation from target for all three of the objectives, so that we could use our fancy-dancy quantitative models to develop both an optimization framework and a risk-management framework. And finally, we would want to know the guidelines regarding which tools, with what horsepower, we could use in pursuing the objectives.

We would treat the assignment as one of “constrained discretion.” And once the terms of the portfolio management assignment were agreed, we would negotiate a communication strategy with the client, so as to minimize the chance for “surprises” on either side. Yes, that’s how we’d go about it. We would want flexibility in the day-to-day management of the assignment, but we would also want the terms of that flexibility to be well understood, all in the context of well-defined goals, objectives and reporting requirements.

Mr. Greenspan would not be comfortable with the PIMCO style. He has long argued for maximum flexibility for the Fed, with minimum quantification of the Fed’s goals. In a nutshell, Mr. Greenspan’s management style is best described as “trust me” – sometimes known as “constructive ambiguity.” In the investment management business, such a style is often referred to as a hedge fund style, which has actually become a misnomer since LTCM went down in ashes practicing that style. Goal specification and transparency are now the watchwords of the hedge fund business, even as hedge fund managers continue to demand flexibility in pursuit of stated goals. Call it “constrained discretion.”

Jackson Hole Hubris
Not so, Mr. Greenspan: he still revels in the role of shrouded puppeteer, answerable only unto himself. This past weekend in Jackson Hole, at the Kansas City Fed’s 27th annual by-invitation-only confab, Mr. Greenspan was crystal clear regarding his policy of non-transparency, declaring:

“In implementing a risk-management approach to policy, we must confront the fact that only a limited number of risks can be quantified with any confidence. And even these risks are generally quantifiable only if we accept the assumption that the future will replicate the past. Other risks are essentially unquantifiable–representing Knightian uncertainty, if you will–because we may not fully appreciate even the full range of possibilities, let alone each possibility’s likelihood. As a result, risk management often involves significant judgment on the part of policymakers, as we evaluate the risks of different events and the probability that our actions will alter those risks.

For such judgment, we policymakers, rather than relying solely on the specific linkages expressed in our formal models, have tended to draw from broader, though less mathematically precise, hypotheses of how the world works. For example, inference of how market participants might respond to a monetary policy initiative may need to reference past behavior during a period only roughly comparable to the current situation.

Some critics have argued that such an approach to policy is too undisciplined–judgmental, seemingly discretionary, and difficult to explain. The Federal Reserve should, some conclude, attempt to be more formal in its operations by tying its actions solely to the prescriptions of a formal policy rule. That any approach along these lines would lead to an improvement in economic performance, however, is highly doubtful. Our problem is not the complexity of our models but the far greater complexity of a world economy whose underlying linkages appear to be in a continual state of flux.

Rules by their nature are simple, and when significant and shifting uncertainties exist in the economic environment, they cannot substitute for risk-management paradigms, which are far better suited to policymaking. Were we to introduce an interest rate rule, how would we judge the meaning of a rule that posits a rate far above or below the current rate? Should policymakers adjust the current rate to that suggested by the rule? Should we conclude that this deviation is normal variance and disregard the signal? Or should we assume that the parameters of the rule are misspecified and adjust them to fit the current rate? Given errors in our underlying data, coupled with normal variance, we might not know the correct course of action for a considerable time. Partly for these reasons, the prescriptions of formal interest rate rules are best viewed only as helpful adjuncts to policy, as indeed many proponents of policy rules have suggested.” 1

As I said Friday here in Newport Beach, while Mr. Greenspan was delivering his address: he doth protest a bit too loudly. Mr. Greenspan’s critics, including me, have never faulted Mr. Greenspan for employing risk management techniques in the implementation of monetary policy. Quite to the contrary, we applaud the Fed for thinking in risk management space, as we say ‘round here. In particular, we at PIMCO applaud Mr. Greenspan for recognizing Pascal’s Wager, that wonderful paradigm of risk management that the great Peter Bernstein teaches again and again: beware of the low-probability event that carries a severe outcome!

That said, I submit that central banking under a “risk management paradigm” – Mr. Greenspan’s ill-defined phrase on Friday – is a poor substitute for what Fed Governor Bernanke calls “constrained discretion.” And this is not just a matter of semantics! On Friday, Mr. Greenspan set up a straw man and then knocked him down, accusing his critics of urging the Fed to tie its operations “ solely to the prescriptions of a formal policy rule.”

Very few Greenspan critics have ever advocated that the Fed tie policy “solely” to some policy rule. I know I haven’t! And after uttering his opening broadside against his critics, even Mr. Greenspan acknowledged this, declaring, “ the prescriptions of formal interest rate rules are best viewed only as helpful adjunct to policy, as indeed many proponents of policy rules have suggested.” This is indeed the case. In fact, many of Mr. Greenspan critics – and I would include Fed Governor Bernanke in this camp – are not even advocating a “formal interest rate rule” for policy, even as an adjunct to policy.

Rather, what we want is simply quantification – a definition, if you will! – of the Fed’s mission. To be sure, Mr. Bernanke used to be an “inflation targeter,” and probably still is in his heart. But as a Fed governor, his advocacy position has been simply that the FOMC should define – repeat, simply define! – “price stability:” not as a point, but as a range. Yet Mr. Greenspan refuses.

Vincent Has It Right
I will see Mr. Bernanke’s ante and up him: I’d like the FOMC to also define – repeat, simply define! – “maximum employment,” translated into a range of values for the non-accelerating inflation rate of unemployment, commonly known as NAIRU. To my way of thinking, a definition of both price stability and maximum employment would be a giant step forward in Fed transparency, just like the specification of benchmarks lies at the core of active portfolio management.

Such transparency need not limit the Fed’s operational flexibility. In fact, I submit that public disclosure of such definitions would actually enhance the Fed’s flexibility, by “anchoring” (the new favorite word of Fedwatchers!) market expectations of what constitutes “neutral” monetary policy.

In this connection, such definitions of the Fed’s goals need not be eternal, and should not be eternal; stuff happens, structural changes unfold, and risk preferences evolve. We see this all the time with PIMCO’s clients, who change their benchmarks and/or their guidelines when circumstances/facts change. There is nothing wrong with this, but something very right. We work together to make the changes.

But Greenspan disagrees, when it comes to carrying out his job mission. His definitions of the Fed goals are what his gut says they are, but what he cannot bring his lips to say, subject to change when he has an undisclosed stomach ache. Broadly speaking, such a paradigm has worked for him, with both inflation and unemployment relatively low. Such a paradigm is not, however, an institutional framework for monetary policy management; rather, it is a maestro-digm . As FOMC Secretary Vincent Reinhart sagely noted on Saturday in Jackson Hole:

“Someone ultimately has to be responsible for forming a view on the economy and framing the policy response. In the United States, the Congress has determined that this responsibility should fall to the Federal Reserve. That the central bank should not abdicate its responsibility for setting interest rates by transferring it to the market is one issue that has an easy answer.”

Mr. Reinhart is right: the buck does stop somewhere, and it’s the Federal Reserve. The Fed is a price setter, while we in the financial markets are but price takers . And, as Mr. Reinhart also said (my emphasis, not his):

“…it is important to remember that the Federal Reserve’s control of the federal funds rate has direct consequences for only a small segment of spending. That control, however, can be a powerful lever if market participants reliably embed the current and expected future path of the overnight rate into the full range of asset prices . But investors will only act on sensible beliefs. That is, a central bank’s decision must be seen by them as consistent with a reasonable view of likely economic outcomes, a sense of how to weight those potential outcomes given the attendant risk, and a predictable policy response to that economic scenario.”

What is missing in the current environment, to borrow Mr. Reinhart’s words, is a “ predictable policy response.” To be sure, the FOMC has told us that it will remain accommodative for a “ considerable period.” But the FOMC has not told us either its definition of price stability or full employment. Therefore, the markets cannot reliably predict the length of a “ considerable period.” Accordingly, the fixed income market is “buying insurance” against uncertainty as to the Fed’s intentions by pricing in some 200 basis points of Fed tightening next year.

Bottom Line
If Mr. Greenspan ever wanted evidence of the cost of his infectious hubris, he need not look any further than the money market futures market, as displayed on the cover. Unconstrained discretion, as Mr. Greenspan advocates, is not a free good, because it raises risk premiums for uncertainty about monetary policy, acting as a headwind to the FOMC’s accommodative will.

In contrast, constrained discretion, with full scope for the Fed to react to shocks, offers the scope for the financial markets to transmit most efficiently the impulse of the Fed policy actions to where it matters – the real economy, where 130 million Americans get up and go to work each morning. And where another 2 million who’ve lost their jobs over the last three years wish they could go.

Constrained discretion works, Mr. Greenspan. We practice it everyday here at PIMCO. We cherish our flexibility, as do all successful active portfolio managers. We also believe that transparent discussion of our philosophy and process – our reaction function, if you will – enhances our ability to add value to clients’ portfolios, disciplined by an equally-transparent risk management process.

Give it a try, Mr. Greenspan. I submit that you would be amazingly liberated by the increased degrees of freedom that would come with increased transparency about your degrees of freedom.

In the matter of trust, Sir, sunshine is a great disinfectant.

Paul A. McCulley
Managing Director
September 1, 2003

1 Greenspan, Monetary Policy Under Uncertainty, Jackson Hole, WY, Aug. 29, 2003


Past performance is no guarantee of future results. This article contains the current opinions of the author but not necessarily Pacific Investment Management Company LLC. This article is distributed for educational purposes only 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 reliable, but not guaranteed. The credit quality of the holdings in a portfolio does not apply to the stability or safety of a portfolio. Duration is a measure of price sensitivity expressed in years. Alpha represents a fund’s risk-adjusted performance (the difference between a fund’s actual returns and the expected performance, given the fund’s level of risk as measured by beta). No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission of Pacific Investment Management Company LLC (PIMCO). Copyright 2003 PIMCO.