Global Central Bank Focus

At Seventeen

"After what I heard at Jackson Hole, policy makers are going to want to see a lot of those downside surprises before turning to easing."

A conversation with Morgan le Fay, the author’s family pet and usual early morning debating partner)

PM: Good evening, Princess. Wanna chin wag?

MLF: Sure, Mac. But why are you asking? You talk to me all the time, though usually at four in the morning. Why now, during what creatures walking on two legs call the happy hour? What’s up?

PM: Two things, Ms. Morgan. First, while we chin wag all the time, we only do it for the record once a year, in December, when we contemplate the year ahead. We’ll probably do it again this year, but given that the US economy is at a major cyclical inflection point, I think it would be useful to explore on the record right now, drawing on your wisdom and inquisitive mind.

And second, I just got back last night from Jackson Hole, where I attended the Kansas City Fed’s annual symposium, and I had to go to work this morning. So, talking with you will be my happy hour this evening. Okay?

MLF: Whatever. Knew you were gone, because I didn’t get fed twice a day like when you are here, but only once. Why didn’t you call Jonathan twice a day to remind him to feed me? What’s with 17-year olds these days?

PM: Sorry, Princess. Will remember that on future trips. As to what’s with 17-year olds, they are 17-year olds, Morgan. It’s a tender age. Always has been and always will be, as parents like me have to remind ourselves when we get frustrated in trying to divine the un-divinable.

We were 17 once ourselves, we have to remember, and our parents were right when they said we wouldn’t understand their frustration with our moodiness until we had teenagers of our own. I’ll speak to Jonnie.

Meanwhile, let’s talk about something that I think is a bit more divinable, though maybe not a lot more: the ways and means of Fed policy, in the context of a more globalized economy. Which was what the Jackson Hole confab was all about.

MLF: Okay, dude. Was this Jackson Hole thing a secular discussion, like you guys have at PIMCO every May, focusing on the next 3-5 years, or was it a cyclical discussion, like you guys have quarterly, focusing on the next 6-12 months?

PM: Actually, it was both, Morgan. The official discussions were secular in nature, while the informal discussion were cyclical in nature. The official agenda focused on the meaning of a flatter world, in the words of New York Times columnist Tom Friedman. Globalization, it’s technically called. The key questions on the official agenda were:

  • Is globalization disinflationary, inflationary, or both?
  • Does globalization promote growth, increase geographic disparity of growth, or both?
  • Does globalization increase global income inequality and, if it does, should that matter for central bankers?

MLF: Heady stuff, Mac. Very similar to PIMCO’s Secular Forum , indeed. By the way, were there any former Secular Forum speakers there?

PM: Several, actually, Princess. The most famous was none other than Fed Chairman Ben Bernanke himself, who was with us in 2000. Also in attendance were Harvard economist Martin Feldstein, who was with us in 2004 and 1993, and St Louis Fed President Bill Poole, who graced PIMCO way back in 1985, when he was an economics professor at Brown University .

We have rather renowned guest speakers at our Forum , Morgan. And I gotta hunch that future Forum speakers were also in the room at Jackson Hole.

MLF: Know that, Mac. Now cut to the chase: Is this globalization thing disinflationary or inflationary? How could it be both?

PM: In the first instance, it is disinflationary, Morgan, as it represents a positive supply side shock. The best example goes back to 1978, when China decided to shuck off economic isolation and become part of the global economy.

That was a long, long time ago, to be sure, but marked the beginning of a positive supply side shock to the rest of the world: labor and savings resources previously not on offer to the rest of the world have been coming on line ever since, increasing supply potential relative to ex-China realized demand. Thus, in the first instance, which has been a very long instance, globalization is disinflationary.

MLF: Through that invisible hand of competition that we talked about last December, Mac? 1

PM: Yes, grasshopper, you remember well. In this case, the invisible hand brought forth increased supply of both labor and savings, which put disflationary pressure on both real wages and real interest rates in the developed world.

Textbook stuff, really. Competition is always and everywhere a disinflationary force.

MLF: Hold on here! Don’t central bankers believe that inflation is always and everywhere a monetary phenomenon?

PM: They preach that they do, Morgan, but if you scratch them a bit, they will elaborate a bit more fully. Yes, in the very long run, inflation is a monetary phenomenon, as inflation is all about nominal values, as in the number of dollars and cents that it takes to buy something.

But nominal values are but a veil on the real economy, where the forces of the invisible hand do matter. In the long run, Morgan, central bankers do have the ability to control inflation, but that power must be exercised in the real world in real-time, where real variables, directed by the invisible hand, are the primary determinants of inflation.

MLF: Not following here, Mac. Can you give me an example?

PM: Sure. Indeed, here’s the one that we discussed in Jackson Hole: Phillips Curves in the industrial world, particularly the United States, have become much flatter as the result of globalization.

That is, the trade-off between unemployment and inflation in the United States has become weaker, because labor costs embedded in the products and services we consume in America are a function of not just US wages, but global wages, which are a function of both expansion and slack (unemployment) in the global labor market.

This is hugely important for Fed policy, because a flatter Phillips Curve, sometimes also called a higher Sacrifice Ratio, means that the Fed need not worry that a falling US unemployment rate will quickly generate a rapid acceleration in US wage-driven inflation, as US labor’s pricing power is diminished by competition from an augmented global labor supply.

This is good news. It is also bad news, many in Jackson Hole argued, in that if the Fed takes too much comfort in the good news, letting the inflation rate creep ever north of its so-called comfort zone, a flatter Phillips Curve means that the Fed would have to take unemployment higher and for longer than used to be the case to get inflation back down.

MLF: So, what you are telling me is that while the Fed can still be rightfully held responsible for long-term inflation outcomes, the ways and means of inflation control over cyclical horizons, which are tied to the Phillips Curve, have changed?

PM: Fair summary, Morgan, very fair. Indeed, this reality was the connection between the official and unofficial discussions at Jackson Hole. We all agreed that globalization secularly flattens the cyclical Phillips Curve.

But beyond that, there was huge debate and disagreement about exactly what this implies for the conduct of monetary policy. In particular, there was a huge philosophical debate about the role of inflationary expectations in the cyclical inflation processes.

MLF: What do expectations have to do with it, Mac? Isn’t the Phillips Curve all about realized slack, or lack thereof, in the labor supply? Where do expectations fit in? Slack is slack or it ain’t slack, no?

PM: This is where it gets really interesting, Princess. You’re at the cutting edge of the debate, which centers on the connection, or lack thereof, between price and wage setting in the real world and something called the Fed’s “anti-inflation credibility.”

In the first instance, as you suggest, Morgan, producers, consumers and workers negotiate about prices and wages in the context of what they see in the real world, based upon competitive forces.

For example, there are three places within five minutes of here where I can buy your favorite romaine lettuce, along with groceries for me and Jonnie. I know that and the three stores know that, owners and workers alike. We are all grown-ups and know that the invisible hand will direct us the right way: I will shop where I get the most value for my buck and the owners and workers will make the most where they provide the most value for my buck.

Owners can’t set their prices independent of the competition and workers in those stores can’t demand wages that are inconsistent with the owners making money. Competition rules!

However, according to the inflation expectations argument, we all know just how much inflation the Fed will or won’t tolerate, which becomes the backdrop for our competitive game. For example, if I know, or at least I think I know, the Fed won’t tolerate anything north of 2% inflation, then I will balk at paying anything more than that, sitting on my hands until one of the grocers recognizes my understanding of reality and sets his prices accordingly, perhaps encouraged by his workers who fear for their jobs.

To be sure, this would mean that you would have to go without your romaine for a few days, which I would never let happen. But let’s not let reality interfere with a good theory!

And actually, it is a good theory: expectations of inflation – conditioned by expectations of just how much inflation the Fed will or will not tolerate before jacking interest rates, so as to throw some people out of work – do matter.

Thus, the Fed’s anti-inflation credibility does matter in the inflation process, not just the literal supply/demand conditions in the market for goods and services. This is particularly the case when the economy is hit by an adverse shock to inflation, such as a surge in oil prices.

By definition, such a shock will lift actual printed inflation, as the case has been over the last two years. But if the Fed has high anti-inflation credibility, producers, workers and consumers will not extrapolate higher printed inflation as a sign of what inflation will be over the long-run, but rather treat the oil shock as a one-off hit to the level of real incomes, which simply must be tolerated.

This wasn’t the case in the nasty 1970s of my youth, of course, when higher printed inflation borne of oil price shocks led pro ducers, workers and consumers to anticipate permanently higher inflation, which became a self-fulfilling prophecy, until the Fed, led by Chairman Paul Volcker, induced a blood-curdling recession.

Thus, there is good reason for policymakers to want to preserve their anti-inflation credibility: it increases the odds that one-off price shocks remain one-off price shocks, rather than a self-feeding, accelerating inflationary process.

MLF: This is more than a little confusing to me, Mac, when normally I understand you pretty well. But I did hear that you are not going to ration my lettuce, no matter what happens to the Fed’s anti-inflation credibility, right?

PM: Rest easy, Princess, you never have to worry about your lettuce supply, I promise. The reason this stuff is hard to explain is because it’s actually the toughest analytic problem in modern macroeconomics: how much do inflation expectations matter in the wage and price setting processes, and how much should they influence central bank behavior?

Both at and away from Jackson Hole, people who do what I do for a living all agree that expectations matter, but there is no clear consensus on just how much they matter or just how much the Fed should try to flat-line those expectations. I’m on what is called the “dovish” end of the spectrum in this debate.

MLF: So, you’re talking to birds now, too, not just rabbits?

PM: No, Morgan, in the central bank game, doves are people who believe that the Fed should think long and hard about throwing people out of work, while hawks are people who believe the Fed should think long and hard about not throwing people out of work, if and when it appears that inflation, or worse yet, inflationary expectations, rise above some self-proclaimed “comfort zone.” Neither the doves nor the hawks can claim to be unambiguously right, because there is an element of truth to the propositions of both camps. In the end, it’s not just an empirical matter, but a matter of value judgments, mixed with differing degrees of faith in understanding how the economy works. Which is what makes an event like Jackson Hole so interesting!

MLF: Okay, but we ain’t got all evening. Again, I must ask you to cut to the chase. What does this mean right now in what you do at your job?

PM: Fair enough. Right now, the global capital markets are discounting the following cyclical scenario:

  • The US economy is slowing quite sharply, in the wake of the negative real effect of elevated energy prices, a property market moving rapidly from boom to bust, and more generally, the lagged effect of two years of Fed tightening.

  • US inflation is above the Fed’s 1%-2% comfort zone, but the Fed was right to quit tightening at its early August FOMC meeting, as inflation is a lagging variable, notably of economy activity, which is slowing dramatically. In the fullness of time, inflation will follow.

  • As growth falls below trend, portending a lagging return of inflation back toward the Fed’s comfort zone, the Fed will gingerly start to ease, probably by mid-year next year, so as to ensure that the economy experiences a soft landing rather than a recession.

Broadly speaking, Morgan, we at PIMCO agree with this cyclical scenario embedded in market prices, though I hasten to add that we will be formally updating our forecasts at our Cyclical Economic Forum next Thursday. I’ll share the results with you, Princess, after I write my Morning After memo.

But I feel pretty comfortable that we will be in the same ballpark as what the markets are discounting now. Personally, I’m probably a tad more bearish on growth than the markets right now, but also probably a tad more bearish on inflation, meaning that I think it will probably remain elevated a touch longer than the market consensus view.

MLF: So are you a closet hawk on inflation, Mac? Are you no longer a principled populist? You going hard on me?

PM: No, Morgan, not at all! Rest assured, I will always be a dove. Not that I’m always and everywhere against Fed tightening. There have been many times in my career when I’ve advocated tightening, at times more than the Fed’s hawks. That has not been the case this cycle, of course, but I’ve been in this game for a long, long time.

I believe the burden of proof for tightening goes up, and goes up dramatically, when monetary policy is obviously restrictive, not neutral, as measured by the slope of the yield curve, which is presently inverted.

This is particularly the case when I observe that corporate profits as a share of GDP are at a half-century high, while real wages are struggling to stay above the zero line. Make no mistake, Morgan, this recovery has been a boom for capital, not for labor!

In fact, that was the dirty little secret at Jackson Hole that nobody seemed to want to talk about candidly. Yes, it came up, with my pal Bill Dudley actually putting it on the table in one of the formal sessions, to be met by the sound of one hand clapping. There was no serious discussion of the matter of the return to capital versus the return to labor, because, I think, it is too painful for many central bankers to talk about; income distribution issues ain’t their job, they fervently argue.

And in a narrow sense, I agree. In a broader sense, however, I disagree, because I believe the Fed’s cyclical reaction function should be consistent with a secularly equitable distribution of the fruits of productivity gains. In fact, Morgan, I urge you to read an excellent article 2 by Steven Greenhouse and David Leonhardt on the front page of today’s New York Times, which details just how much capital is reaping the fruits of productivity relative to labor in this cycle.

Historically, capital and labor have shared in the fruits of productivity, with capital leading the way, giving way to labor as the cycle matures and unemployment drops to its putative full-employment level.

As a mechanical matter – literally, a mechanical matter – this implies rising unit labor costs, or as I prefer to say, rising unit returns to labor. The flip side, of course, is decelerating unit returns to capital, also known as unit profit margins. This is straightforward text book stuff.

MLF: If that’s the case, why is there any debate about it, Mac?

PM: Because also as a mechanical matter, cyclical periods of rising inflation tend to be associated with rising unit labor costs. That is, capital doesn’t go quietly into the good night, simply surrendering unit profits to unit returns to labor, but rather tries to protect its share.

Nothing wrong with that per se; it’s just the invisible hand of competition working over time. But it does tend to push inflation up cycli cally, at least somewhat. This doesn’t bother me. But it does bother central bankers worried excessively about their anti-inflation credibility.

Fortunately, I don’t think this includes Chairman Bernanke, though I would be a touch more comfortable in saying that if he was a touch more open about his acknowledged need for an open debate about the sanctity of the Fed’s 1%-2% “comfort zone” for the core PCE deflator. Is it too low and is it too narrow?

These are legitimate questions, I believe, which did get some corridor (and mountain) air in Jackson Hole, even while the official discussion of the implicit inflation target went the other way, with the European contingent arguing that the Fed should be targeting headline, not core inflation.

MLF: Okay, Mac, for the sake of argument, let’s say you’re right; the comfort zone is too low to allow for labor to get some just fruits of its productivity. Let’s further say this means, again just for the sake of argument, that the comfort zone should be 2%-3%, or perhaps 1%-3%, not 1%-2%.

Would not the Fed announcing such a change be a disastrous blow to its anti-inflation credibility? Would this not be the gravest injustice to labor, if an honest attempt to let them get some of the fruits of their productivity ended up letting the inflation-expectations genie out of the bottle, setting off a wage-price spiral that would require the Fed to clamp down with recession, like Mr. Volcker did?

Don’t you understand the “slippery slope” argument, Mac?!?! Didn’t somebody lecture you somewhere in Wyoming about it?

PM: Rest assured, I understand the argument, Princess. And rest assured, several very senior officials lectured me bluntly about it at Jackson Hole. The slippery slope lives, even when everybody acknowledges that it has become less slippery, as least as implied by a flatter Phillips Curve.

In this context, one senior official, well known as a hawk, conceded to me that there probably is a good case for a somewhat higher comfort zone. But then he explained to me in grandfatherly fashion that the Fed simply can’t do so, because the FOMC has preached the 1%-2% zone so loudly for so long. Wouldn’t be prudent for the FOMC’s anti-inflation credibility!

All the while, there was a general consensus in the Tetons that the FOMC is acting as if the comfort zone is somewhat higher, just not saying so.

I actually have no problem with that, though I would prefer honesty in the matter. If the comfort zone is too low, it is too low. And I believe the Fed could explain that without any loss of anti-inflation credibility.

But I also concede there is a risk the other way. Thus, I’m content with the FOMC acting as if the comfort zone is higher for now, while waiting for a more propitious time to formally acknowledge reality. The next easing cycle, which by definition will be about downside risks to growth, not upside risk to inflation, would be an ideal time.

MLF: Bet over half of the people at Jackson Hole would say you are dreaming about that zone ever being formally lifted. But who am I to argue with you? After all, I’m just a talking rabbit named after a fairy who was a myth.

Meanwhile, time for you to hit the sack, so let’s wrap this up. What’s the bottom line for you and PIMCO after the three big events of August: a bond market rally, a Fed that didn’t hike for the first time after 17 FOMC meetings, and what you heard in Jackson Hole?

PM: Thanks for being aware of my need for sleep, Morgan. You are an expert on the subject as well as a committed practitioner, I’ve observed. The bottom line is that the economy is cyclically evolving as we anticipated, albeit admittedly later than we anticipated. And the Fed is properly on hold right now, notwithstanding sticky inflation on the upside. We’ve been positioned accordingly, and the last couple months have been sweet for performance.

Tricky thing going forward is that the market is so fully priced for our scenario, notably that the Fed reverses course to easing next year. We still believe that and believe it strongly, as we are convinced the property market is going to continue to surprise on the downside and the knock-on effect on consumer spending and job creation is also going to surprise on the downside.

But I have to admit that after what I heard at Jackson Hole, policymakers are going to want to see a lot of those downside surprises before turning to easing. Right now, they are willing to look the other way about inflation above the too-low comfort zone and resist further tightening, but my gut says that actual easing will be a harder step for them – though certainly feasible – with inflation above the zone. It’ll take weak real-side data, period.

We shall watch and see, adjusting our risk exposures accordingly on a tactical basis. I suggest you do the same, Morgan.  

Paul McCulley
Managing Director
August 28, 2006

1 MEW Drag,” Fed Focus, December 2005,
2 “Real Wages Fail to Match a Rise in Productivity” New York Times, August 28, 2006,


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