Home > Insights > Trade Your NAIRU Jacket For Some CAPRI Pants​

My son Jonathan, twelve years old, recently made a declaration: the Old Man has become an Old Fart. Quite naturally, I was not ecstatic about the change in moniker, and asked for an explanation. He plaintively explained there were two compelling pieces of evidence, both deeply embarrassing to him: (1) I frequently venture out of the house on the weekend, insisting that he accompany me, with the collar turned up on my polo shirt; and (2) I return from the barbershop with hair still touching, if not reaching over, the top of my ears. These two offenses, Jonnie declared, are truly signs of an Old Fart. If I want him to more joyfully join me on outings, he urgently pleaded, I need to “turn down the collar and trim up the hair.”

I’m thinking about it. The collar part is easy, but I’m not sure about taking barbering directions from a twelve year old. Indeed, the irony of my son badgering me to get a close haircut, like he does, after having my own Old Man badger me over thirty years ago to do the same thing, is just a bit too much for me to take. Why is it that men of my generation worry about these things? Were we stripped at birth of sovereignty over hair matters? All I ever wanted from my Pops on the hair front was the right to wear it my way, not his. Now my son wants not just the right to wear his own his way, but to have me wear mine his way, too.

Thinking about propping a compromise to him: when he and I venture out to the Farmer’s Market on Saturday, I’ll turn down my collar and put on a ball cap to cover my mop of hair, provided that he put on his own ball cap with the bill in front, rather than back! Ah, the joys of being a father; can’t beat it, even if it beats you. Next project will be to convince Jon that (1) a day of fishing doesn’t necessarily have to involve catching fish to be a day well spent; and that (2) sassing his Mom is, as we say in the bond business, a negative convexity trade with negative yield – don’t do it! Yep, gotta teach him all these important things. That’s what Pops do, even when they’ve become Old Farts.

The CAPRI (Cyclically-Accelerating Profit Rate Of Inflation)
Is Above The Current Inflation Rate

Figure 1 is a line graph that charts the Philadelphia Fed Prices Received index, or Diffusion Index, against U.S. corporate profits, from 1982 to 2002. Both metrics, which are superimposed, roughly track each other over the period, ending at around the same point on the chart in late 2001: the four-quarter moving average of the Diffusion Index, scaled on the left-hand vertical axis, is at about negative 8%, near its lowest point on the chart. Similarly, year-over-year change in corporate profits is around negative 12% at that time. Both metrics peak near similar times over the period, in the mid-1980s, the late-1980s, the mid-1990s, and the early 2000s. Both metrics also trend downwards over the time span shown.
 
Figure 1
Source: Philadelphia Fed Business Outlook Survey, Bureau of Economic Analysis

Alan Greenspan: Old, But Not An Old Fart

Chairman Greenspan has never been a fan of the macroeconomic notion of the “non-accelerating inflation rate of unemployment,” popularly known as the NAIRU. Essentially, NAIRU is the sweet spot on the Phillips Curve, which posits a trade-off between the inflation rate and the unemployment rate. More specifically, NAIRU is the cusp beyond which falling unemployment starts to become associated with accelerating inflation, the spot at which Fed policy makers are ostensibly supposed to stop the unemployment rate from falling further. ‘Cause, of course, accelerating inflation is bad, so nasty that avoiding it warrants having a “reserve army of the unemployed” to preempt it.

No wonder, then, that Alan Greenspan has always been reluctant to wear a NAIRU jacket in public. Greenspan is, after all, a card carrying Libertarian capitalist, and it would be embarrassing for him to admit that the Fed’s job sometimes involves running a draft board for the “reserve army of the unemployed.” A Libertarian wearing a Marxist ball cap is just not a pretty sight, even if worn with bill facing forward!

What is more, if Greenspan were to admit that a NAIRU exists, everybody would want to know his estimate of the damn thing, particularly those nasty Congressmen elected by the democratic process. Wouldn’t want that, of course, because if the actual unemployment rate were to rise above his estimate of the NAIRU, the Fed would get the blame; and if the actual unemployment rate were to fall below his estimate of the NAIRU, the Fed would have to explain why it “needed” to throw somebody out of work.

Philosopher kings, like Mr. Greenspan, know that some things are best left un-estimated, un-forecast, and un-said. Unless, of course, there is no choice, in which case euphemism, obfuscation and smoke-blowing should be the tools of first resort. In which case, Mr. Greenspan never publicly worries about too few conscripts for the “reserve army of the unemployed” to prevent accelerating inflation. Rather, Mr. Greenspan occasionally worries that “the pool of available workers” may be shrinking too quickly.

Indeed, that was the Fed’s predominant worry for most of the second half of the 1990s, once the actual unemployment rate dropped decisively below 5½% in the summer of 1996. Conventional wisdom had, for a long time, held that the NAIRU was in a 5½%-6% zone. And at the Fed, a reservoir of conventional wisdom, if a policy maker refused to wear a 5½%-or-higher NAIRU jacket, he or she was considered at best, a “dove” and at worst, unfit for the job. If you don’t believe me on this, just a take a Saturday -- while fishing but catching no fish -- to read the full transcripts of the 1996 FOMC meetings, released just a couple of weeks ago (after the customary five year lag).

Policy makers were not a happy bunch, as the fool unemployment rate kept falling below conventional estimates of the NAIRU, but inflation wasn’t going up. This was embarrassing to the group, not just as a bad forecast, but as a possible indictment of the whole notion of running policy on an estimate of the NAIRU; perhaps, they feared, somebody somewhere might just suggest that the Fed had been needlessly keeping people out of work. To his credit, Mr. Greenspan was the least starched about the falling unemployment rate; essentially, he told his colleagues to loosen the collars on their NAIRU jackets. For, you see, it was in 1996 that Mr. Greenspan became a New Age Man.

Specifically, at least for his FOMC colleagues, he outed himself as a New Age Productivity Man at the September 24, 1996 FOMC meeting, forcefully declaring:

 

“If we look at the current structure of costs, hourly compensation for the corporate sector and probably for the whole economy is going up 3½ percent per annum. If output per hour for the overall economy were going up 1½ percent, which seems a lot more likely than the reported numbers, unit labor costs would be rising 2 percent. Multiplying unit labor costs by .7 percent, the general proportion of labor costs in total costs, results in a contribution to total costs of 1.4 percent from the rise in the compensation of employees. Other costs are going down: Indirect business taxes per unit of output are moving lower as are net interest costs. In the most recent period, these declines average about ½ percent, so growth in underlying total unit costs is somewhere in the area of 1 percent. This explains why profit margins are large and holding, and it explains why price pressures are nowhere near as high as we would ordinarily expect them to be at this stage of the business cycle in the context of laggard productivity growth.

The answer is that we can explain it only if productivity is indeed rising a lot faster than our statistics indicate. If this analysis is in fact correct, it is important for us to take a look at what it implies about the current performance of the economy and the underlying inflationary forces. While the probability is still better than 50/50 that we will not get through this period without the very strong pressure on wages overcoming the productivity costs, I think the probabilities are falling. Indeed, there is not inconceivable probability that we could get through this period into the early months of next year without moving policy.”

These, friends, were the words of a man who just didn’t like wearing a NAIRU jacket, despite the fact that the unemployment rate had just dropped from 5.5% to 5.1% the prior month. The problem at hand, he argued, was not too many Americans working, but rather too little analysis, and too little recognition that Americans were working more productively. Accelerating wages need not be inflationary, and indeed definitionally were not inflationary, he argued, if corporate profit margins were “large and holding.” That configuration could only be the case if productivity was accelerating, Greenspan declared, and that was a cause for joy, not a justification for tossing people out of work .

Very cool thinking: Mr. Greenspan most definitely was not becoming an Old Fart, but rather a New Age Economy Man. The Fed should let the New Age Economy run, he argued, because fundamentally, he saw a “once or twice in a century” technology shock that was structurally boosting productivity growth. Such shocks are what progress is all about in a capitalist economy: the rich get richer, but so do the poor, as the fruits of productivity growth are reflected in rising real wages. To wit, when there is a positive productivity shock, the NAIRU, if you believe in such a thing, falls! Indeed, on July 20, 2000, in testimony before Congress, Greenspan almost let himself be “cornered” into declaring his own estimate of the “new” NAIRU: 4%!

 

Senator Mack: “…in your view, can we achieve price stability with unemployment at 4 percent or do we need to move the unemployment rate back higher in order to achieve price stability?”

Chairman Greenspan: “I think the evidence indicating that we need to raise the unemployment rate is unpersuasive in my judgment. It’s a major issue in the economics profession, under significant debate. My forecast is that the NAIRU, which served as a very useful statistical procedure to evaluate how the economy was behaving over a number of years, like so many types of temporary models which worked, is probably going to fail in the years ahead as a useful indicator, as least in anywhere near as useful indicator, as it was through perhaps a 20-year period up until fairly recently.”

Senator Bayh: “I gather from your response to the early part of the question, you believe that you can maintain price stability, you can – with unemployment at 4 percent?”

Chairman Greenspan: “I don’t know that for sure. Indeed, in my prepared remarks, I did indicate that that is an open question. I suspect, yes, but I must say that the evidence other side of this question not yet of sufficient persuasiveness to convince everybody.”

The bottom line: Greenspan doesn’t like NAIRU jackets, but if you’re gonna make him wear one, give him a size four, please. He ain’t no Old Fart.

Greenspan Actually Prefers CAPRI Pants

In Congressional testimony last Wednesday, February 27, Mr. Greenspan refused to wear a NAIRU jacket at all, in contrast to the Wall Street consensus that he’d sport one woven from goat hair, threatening to “take back” last year’s easing, as soon as the unemployment rate stops rising. In point of fact, Mr. Greenspan actually yearned for a cyclical increase in inflation, so as to (1) undergird firming in corporate profit margins, so as to (2) undergird prospects for a revival in business investment. Say what, you say?!? You don’t need to take my word for it. Here’s what Mr. Greenspan said, verbatum:

 

"…part of the reduction in pricing power observed in this cycle should be reversed as firming demand enables firms to take back large price discounts. Though such an adjustment would tend to elevate price levels, underlying inflation cost pressures should remain contained. To be sure, output per hour is not likely to accelerate this year as much as in a typical recovery because businesses have not delayed, as they did in past recessions, shedding workers at the first indication of weakened demand. But slack in labor markets and further increases in productivity should hold labor costs in check and result in rising profit margins even with inflation remaining low. Improved profit margins and more assured prospects for rising final demand would be accompanied by a decline in risk premiums from their current elevated levels toward a more normal range. With real rates of return on high-tech equipment still attractive, that should provide an additional spur to new investment."

Mr. Greenspan is indeed a New Age Economy Man. He’s no Old Fart at all. And he’s no Cowardly Lion, either. He had the courage to say that it's okay for product prices to normalize up as improving demand mitigates the need for discounts, and that such a normalization would not be an inflation problem, but rather a profit-margin deflation solution. If investors would just believe in him, he mused like the Wizard that he is, they'd bid down equity and credit risk premiums, making him look like a hero yet again. Rather than wearing a NAIRU jacket, Mr. Greenspan donned CAPRI pants, in search of the Cyclically-Accelerating Profits Rate of Inflation.

Mr. Greenspan declared plainly that the CAPRI is higher, not lower, than today’s inflation rate. To wit, he wants aggregate demand to firm sufficiently for companies to be able to “take back” prevailing price discounts. That’s the “take back” that is on his mind, not the bond market’s fear of a “take back” of last year’s easing. Simply put, and this is probably the clearest asset allocation call you’ll ever hear from him, Mr. Greenspan wants stocks to outperform bonds in the quarters ahead. And he’s willing to underwrite a cyclical increase in inflation to bring about that outcome.

In fact, one day after testifying before Congress to this effect, Mr. Greenspan reinforced his stocks-over-bonds asset preference in a philosophical speech (that the media essentially ignored) to the Labor Department’s 2002 National Summit on Retirement Savings:

 

“Ultimately, the composition of real investment in our economy will reflect--among other influences--the attitudes toward risk of those who own the financial claims against the capital stock. If savers become more risk-tolerant, financial risk premiums will decline. In response to these reduced penalties on risk, firms will eventually adjust the mix of their endeavors toward more speculative projects -but, importantly, presumably ones that also offer higher prospective rates of return on average, which more often than not translate into higher long-term average economic growth.

The nation's savers, daily in the marketplace, exhibit an obvious sensitivity to the association between expected return and risk. Indeed, many are clearly willing to forgo the higher long-term rates of return on equity for the greater tranquility of the lesser risk associated with most debt instruments--in effect forsaking more economic growth for a more stable, less stressful, economic environment. As a consequence, returns on common stocks over rolling twenty-year periods have almost always outpaced the returns on less risky securities.”

Comfortably Numb in CAPRIs

Mr. Greenspan is not allowed to actively trade his own investment portfolio. But if he were allowed to do such a thing, knowing that the head of the Fed is (1) wearing CAPRI pants, not a NAIRU jacket, and (2) that the head of the Fed believes that a risk-seeking investor culture induces the strongest long-term economic growth, Mr. Greenspan would be buying some stock. He has become comfortably numb to the perils of irrational exuberance. CAPRIs do that to a New Age Economy Man.

Maybe I’ll buy some stocks, too. That’ll impress Jonnie….NOT!

Paul A. McCulley
Managing Director
March 05, 2002
mcculley@pimco.com

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