Global Central Bank Focus

Through Holes In The Floor Of Heaven

"China is not just a supply side force on the global economic stage, but also a Keynesian demand side force!"

Since I’m quick to criticize the Fed’s policy making, I should also be quick to applaud the Fed’s policy making. Here it goes: after this Tuesday’s meeting, the FOMC masterfully communicated a masterful policy design, when it declared:




“The Committee perceives that the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. The probability of an unwelcome fall in inflation has diminished in recent months and now appears almost equal to that of a rise in inflation. However, with inflation quite low and resource use slack, the Committee believes that policy accommodation can be maintained for a considerable period.”




All of us in the markets were focused on whether the FOMC would extricate itself from its ill-advised use of the phrase “considerable period.” It had been introduced on August 12 (and repeated on September 16 and October 28) as a vague commitment in time, rather than a firm commitment linked to “targeted” economic conditions:

 “The Committee perceives that the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. In contrast, the probability, though minor, of an unwelcome fall in inflation exceeds that of a rise in inflation from its already low level. The Committee judges that, on balance, the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future. In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period.”



Many of us had expected the FOMC to simply ditch the “considerable period” phrase, on the theory that first impressions really do matter most, and that “considerable period” was permanently tainted as a time-linked, rather than an economic conditions-linked, precommitment to remaining “accommodative.”

The figure is a bar graph showing the growth of China’s gross domestic product for each year from 1997 to 2002. Each bar breaks down the components of GDP growth into net exports, private investment, private consumption, and government expenditure. In 2002, GDP growth is near 10%, with the chart noting that most growth is composed of private investment, contributing about five percentage points, and private consumption, contributing about three percentage points. Government expenditure made up only about 1%, as do net exports. For all of the years shown, the combination of private investment and consumption make up the lion’s share of GDP growth.

Taking the Taint Off Time


In the event, the FOMC retained the words “considerable period” but removed much of their taint, wordsmithing with the skill of that fellow who used to motorboat about in the toilet tank touting Tidy Bowl. Specifically, the FOMC did two cleansing tasks:



  • Dropped the sentence that “the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future” while altering its assessment of the risk of an unwelcome fall in inflation to “almost equal to that of a rise in inflation.” Bravo! The FOMC got itself off a static, time-linked assessment of the inflation risk distribution (that it will be as it is for the “foreseeable future”) and demonstrated what was always true: the inflation risk assessment is a dynamic one, linked to unfolding economic circumstances, not calendar time.




  • Prefaced the infamous “considerable period” phrase with dynamic enabling variables: “inflation quite low and resource use slack.” Bravo! The FOMC now has an exit strategy from this commitment to remain “accommodative”: when resource use is no longer “slack!”


With this tidy scrubbing of the rhetoric around “considerable period,” the phrase is no longer olfactorily noxious. This is particularly the case after today’s release of minutes of the FOMC October 28 meeting, which revealed that:





“In contrast to the usual experience in economic recoveries during recent decades, the expansion appeared to be gathering momentum at a time when key measures of inflation suggested that price stability had essentially been achieved. Looking ahead, members generally anticipated that an economic performance in line with their expectations would not entirely eliminate currently large margins of unemployed labor and other resources until perhaps the latter part of 2005 or even later. Accordingly and given the presumed persistence of strong worldwide competition, significant inflationary pressures were not seen as likely.”





What is more, the FOMC said:

 “Members referred to the contrast between their current policy expectations and the typical experience during earlier cyclical upturns when it was felt that policy adjustments needed to be made quite promptly to gain greater assurance that inflation would not rise from what were already relatively elevated levels. In present circumstances, the degree of slack in resources and a rate of inflation that was essentially consistent with price stability suggested that the Committee could wait for more definitive signs that economic expansion would otherwise generate inflationary pressures before making a significant adjustment to its current policy stance.”




Those paragraphs, my friends, are a respectful – and proper – funeral for the doctrine of preemptive tightening. 1 May it rest in peace. That said, I still believe the FOMC will want to lose the “considerable period” phrase at the earliest convenient time, not as a signal that tightening is imminent, but rather because the phrase will always be tainted with the connotation of calendar time, even if the FOMC were to hire Marge of Palmolive fame to scrub it.


Beyond that, I expect the whole Fed debate to soon shift from handicapping the time of the first tightening to arguing about what constitutes “accommodative.” Can the Fed honor its commitment to remain “accommodative” even as it hikes rates? Is the hiking of rates an act of non-accommodation, or is the level of the rate after the hike the proper measure of accommodation?


As noted last month, 2 I believe hiking is tightening – non-accommodation! – regardless of the post-hike level of the Fed funds rate. But many, if not most, FOMC members disagree, operating on the Bill Clinton doctrine that hiking ain’t tightening unless you are inhaling a tight level for the Fed funds rate.


So, get ready for the next great slicing of the semantic salami! I’ve got my Williams-Sonoma professional-quality machine ready. But first, when might be the “earliest convenient time” to get rid of a “considerable period?”


My gut says the two-day January 28th FOMC meeting, when the Committee officially blesses the Fed’s Semi-Annual Monetary Policy Report to Congress (formally known as the Humphrey-Hawkins submittal). But I don’t feel religious about this. The phrase doesn’t really bother me that much anymore, now that the FOMC has clearly articulated the nature of the exit strategy from its pledge to remain “accommodative”: the exit will be reactive to both higher realized inflation and higher resource utilization.


Or, as I forecasted last month, the FOMC is unlikely to tighten until (1) the inflation as measured by the core PCE deflator has risen from the low end to the high end of the FOMC implicit 1%-2% definitional range for “effective price stability,” and (2) unemployment has dropped below 5 ½% with auguries of going sharply lower. I anticipate that happening in 2005, with the Fed tightening 1 ½ percentage points to a 2½% Fed funds rate.


But as I also forecasted last month, I fully expect the fixed income market to discount Fed tightening long before the Fed actually tightens. Thus, I expect a cyclical bear market for fixed income markets in 2004; at some point, probably late in the year, two-year Treasuries will probably motor boat toward 3%, with five-year and ten-year Treasuries row boating toward 4% and 5%, respectively.


And the key reason it will be a bear market, even if not a particularly nasty bear, is that reflationary monetary and fiscal policies in America are getting traction: reflation is no longer a forecast, but a reality. When reflation was just a forecast, it was massively bullish for fixed income markets, as it implied that the Fed would drive real short rates into negative territory, pulling down the entire term structure of real rates, while inciting investor appetite for “risk” assets, narrowing risk premiums. There is no better time to be long the fixed income market than when it looks like the world is going to end, despite policy makers’ best Keynesian efforts.


But once it becomes clear that Keynesian reflationary policies are working, the outlook for the fixed income market turns a more ghostly whiter shade of pale. Such is the case now, as the American economy soars on the wings of Keynesian monetary and fiscal stimulus, taking the rest of the world along for the ride. Which brings me to what I really want to talk about this month: I’ve been wrong in declaring that the world suffers from G-1 Keynesianism. The world is blessed with G-2 Keynesianism, but the 2 is not one of the other two traditional G-3 members, Japan and Euroland. Rather, the 2 in G-2 is China !


China : Mercantilist, Yes, But Also Keynesian!


Over the last couple years, I have focused – myopically – on how Keynesian reflationary monetary/fiscal/currency policies were stimulating aggregate demand in the United States . I have lamented that these Keynesian policies have been U.S.-centric, a blessing in a deflationary-risk world, but also sources of ever larger global imbalances. Nobody has bemoaned this G-1 Keynesian lacuna more than I have. My gripes have been:



  • The ECB has needlessly restrained aggregate demand growth in Euroland, shackled by its Calvinistic focus on inflation, while also moonlighting in fiscal policy, insisting on anti-Keynesian, pro-cyclical tightening of budget policies, in democracy-be-damned allegiance to the Growth and Stability Pact.



  • The BOJ has needlessly restrained aggregate demand growth in Japan , resisting following Paul Krugman’s advice to commit credibility to “irresponsible” money printing, explicitly designed to finance an “irresponsible” fiscal bail-out of Japan ’s banking system and foster rising inflationary expectations.


I (and Morgan Le Fay) have wished for G-1 Keynesianism to morph into G-3 Keynesianism, harboring hopes that the falling dollar would act as a deflationary stick in the other G-2 members’ deflationary ears, concentrating their minds and forcing easier monetary and fiscal policies. 3 But we have been disappointed.


In retrospect, I have given far too little attention to China , who’s pegged exchange rate – 8.3 Renminbi to the dollar – de facto makes China part of a monetary union with the United States . Not that I haven’t focused on China . I have, along with all of my colleagues here at PIMCO.


We’ve studied intensely the supply side effect of this arrangement: an ever-larger import penetration into the United States , as China has a huge productivity-adjusted labor cost advantage versus American producers, as well as those of the other G-2 countries. This supply-side impact of China has been acting as a deflationary shock to the rest of the world, hollowing out the high-cost manufacturing base of the G-3 countries. This has been good news for G-3 consumers – what economists call a positive “terms of trade” shock – but bad news for G-3 manufacturing workers.


In turn, many policy analysts, and most certainly the Bush Administration, have been screaming for China to revalue its currency, so as to mitigate “unfair” competition that is destroying G-3 manufacturing jobs. There are many, many things wrong with this argument, as Fed Chairman Greenspan intoned today:

 “The Renminbi is widely believed to be markedly undervalued, and it is claimed that a rise in the Renminbi will slow exports from China to the United States , which according to some, will create increased job opportunities for Americans at home.






“The story on trade and jobs, in my judgment, is a bit more complex, especially with respect to China , than this strain of conventional wisdom would lead one to believe. If the Renminbi were to rise, presumably U.S. imports from China would fall as China loses competitive position to other low-wage economies. But would, for example, reduced imports of textiles from China induce increased output in American factories? Far more likely is that our imports from other low-wage countries would replace Chinese textiles.”





I agree with Mr. Greenspan. But quite apart from that sound argument, the key issue that I have not addressed adequately is that China is not just a supply side force on the global economic stage, but also a Keynesian demand side force! While the Renminbi peg makes Chinese super competitive as a producer, the peg also means that China must run domestic monetary policy in tandem with Federal Reserve policy. 4 During the Asian crisis of the late 1990s, that meant China was forced to follow America’s deflationary monetary policy; but now, the currency peg means that China must follow America’s reflationary monetary policy. Ergo: if America goes Keynesian, China must go Keynesian, too!


And the evidence suggests that reflationary domestic monetary policy in China is working very, very well – perhaps too well, in that China is experiencing a demand boom flirting with a bubble, as displayed in the graph on the cover. And it’s not just for investment to produce for export markets, but investment to build infrastructure to supply the domestic market.


This Keynesian-style domestic monetary policy in China is acting as a pillar of aggregate demand for Asian and emerging countries more generally, as China moves to an ex-United States current account deficit. Thus, the global economy is now benefiting from G-2 Keynesianism: the United States and China .


It is wrong to cavalierly call China a mercantilist country, a sin of which I’m very guilty. To be sure, China retains mercantile proclivities, but unlike Japan at a similar stage of development, China also is an engine for global demand growth. The unfolding global recovery is not just a G-1 Keynesian affair but a G-2 train with China ’s locomotive hooked to the United States .


But you ask: is this a sustainable state of affairs? Yes, China is having a domestic demand boom, and yes, the rest of the world is benefiting, as evidenced by soaring commodity prices and exports to China . But, in the end, is not China ’s domestic demand growth hostage to its ability to continue stealing market share in global markets? Does China really have a self-feeding domestic demand dynamic, circa the United States ? If American demand were to slow sharply, would not the associated slowdown in American demand for China ’s exports reveal the mercantile underbelly of China ’s economy, exposing the domestic demand boom as nothing more than derived demand from its export machine?


I don’t know the answers to those questions definitively, as they can’t be answered definitively, but I can promise you that we will be asking them again and again here at PIMCO. I can’t wait ‘til our next Secular Forum in May!

Bottom Line


Cyclically, the global economy is recovering nicely, in the wake of Keynesian policies in the United States and their (previously-underestimated) counterparts in China , linked to American monetary (and fiscal) policies via China ’s currency peg. The rest of the world is going along for the ride, including the other G-3 areas (where Keynesian demand thought is sprouting green shoots, as evidenced by death of the Growth and Stability Pact). Inflation remains dormant, moribund, or both: Commodities are on a tear, but China is operating as a positive global supply shock, opening and maintaining large unemployment (output) gaps everywhere.


Imbalances remain, notably the U.S. current account deficit. Until China has reached a stage of development that gives it the freedom to de-peg from the dollar, however, the U.S. current account deficit can be funded without undue stress on global financial markets.


To those with Calvinistic tendencies, always looking for what can go wrong, rather than what can go right, the notion of global recovery on the back of a de facto monetary union between the United States and China just doesn’t seem right. And, I admit, I’m not fully convinced yet myself.


But it is what it is: two pegged prices – the Fed funds rate and the Renminbi – set low by fiat, and backed by the printing presses of the Fed and the People’s Bank of China, supporting acceleration in global aggregate demand growth. It is good, very good. And it doesn’t look likely to change in the year ahead.


Through holes in the floor of heaven, Keynes and Minsky weep tears of anti-deflation joy.





Paul McCulley

Managing Director

December 11, 2003


1 See "Comments and Analysis," Financial Times, October 27, 2003

2 Fed Focus November 2003, "When Pleasure Is About Avoiding Pain"
3 Fed Focus November 2003, "When Pleasure Is About Avoiding Pain"

4 Fed Focus October 2003, "Our Currency, But Your Problem"






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