There are a few days in life when you know, just know, that what is transpiring that day will be permanently etched in your memory forever. You know you will remember exactly how the day unfolded, where you were, what you were wearing, what you were thinking, what you said, to whom you said it, and the emotions that engulfed you.

Fortunately, I suppose, there are not too many days like that in most of our lives. And hopefully, most are days of joy, special days involving our loved ones.

But life also involves our professional so journs, and here, too, there are special days. I’ve been a Fedwatcher for almost a quarter century, and there are eight days I remember vividly, as if they were recorded on a DVD in my brain, knowing that what the Fed did and/or said would have long-lasting implications, most notably for asset prices. And with a lag, of course, the economy itself.

For, you see, monetary policy works by inciting changes in financial asset prices, which in turn change the calculus of decision makers in the tangible asset world, sometimes known as the real world.

The Fed’s ultimate objectives – full employment and price stability – are connected to the real world, but the Fed cannot target changes in the real world directly. The Fed can only directly and indirectly target changes in the financial world, through (1) changes in its Fed funds rate instrument, and even more important, (2) talk about prospective changes in its Fed funds rate instrument.

This really is what the Fed does: it pegs the Fed funds rate, which is the rate of return on overnight money – which always trades at par! – and thereby indirectly targets an array of asset prices – sometimes known as “financial market conditions” – in an attempt to elicit outcomes consistent with its ultimate goals for the real economy.

It is often said that the Fed doesn’t do this, that it doesn’t really target asset prices, only the real economy. And technically, that is rhetorically correct, just as it’s rhetorically correct to say my physician doesn’t target my cholesterol level, just the good health of my heart.

But Doctor John (Laura, an awesome dude!) can’t get directly at my heart, while he can get directly – or at least try to! – at my diet. When he briefs me after my annual physical in a few weeks, my keenest interest, I confess, will be in whether he blesses me going back to eating macaroni and cheese. It’s my absolute favorite food, which he took away from me last year (because I was north of 200 on that dreaded cholesterol metric!).

Yes, Doctor John has only my best interests at heart, notably the health of my heart. But he pursues those best interests by either punishing me or rewarding me. Damn him; and bless him!

And the Fed operates in the same fashion regarding the economy’s health, using both deed and word regarding the Fed funds rate to influence the setting of asset prices, which most fundamentally are founded on (1) the opportunity cost of cash and (2) an amalgamation of risk premiums, including a risk premium for uncertainty.

Put less technically, the Fed prescribes and proscribes liquidity conditions, punishing financial markets when we are providing too much stimulus to the real economy and rewarding financial markets when we are providing too little stimulus – or, heaven forbid! – too much restraint on the real economy.

But, just as the case with me and Doctor John, the Fed and the financial markets don’t always see eyeball to eyeball about what is, or isn’t, just the right amount of stimulus or restraint. To wit, there is often a slip between the Fed’s cup and the financial markets’ lip and, in turn, the real economy’s lip.

When such slips reach critical mass, they produce the magical days that I will remember for the rest of my life: the Fed declaring, in act and/or deed, that it is changing the contours of the cup . Last Tuesday was just such a day.

Day Number Eight 

As everybody, including the shoeshine professional at the airport now knows, minutes released last Tuesday of the December 14, 2004 FOMC meeting were more “hawkish” than expected, leading the asset markets to anticipate – “price in,” as we say on Wall Street – a higher trajectory for Fed funds than previously expected.

This, in itself, was no big deal. The FOMC quite regularly nudges market expectations – as to the economic outlook as well as its own reaction function – a touch one way or the other.

Accordingly, the “biggie” paragraph from the minutes quoted in every media outlet in recent days was not the reason I will remember last Tuesday for the rest of my career. Just for the record, here’s that paragraph (my emphasis in all quotes hereafter):

“The Committee’s discussion of policy for the intermeeting period, all of the members (the members of the Board of Governors and the five voting Reserve Bank Presidents) favored raising the target for the federal funds rate by 25 basis points to 2¼ percent at this meeting. All members judged that a further quarter-point tightening in the target federal funds rate at this meeting was appropriate in light of the prospects for solid growth and diminished slack. Even with this action, the current level of the real funds rate target remained below the level it most likely would need to reach to keep inflation stable and output at its potential . With the economic expansion more firmly entrenched, cost and price pressures were likely to become a clearer intermediate-term risk to sustained good economic performance absent further reduction of accommodation.”

The bottom line of that paragraph is simply that the FOMC, collectively, believes that the prevailing real Fed funds rate target ¹ at 0.75% is too low for its visceral macroeconomic taste (2.25% nominal Fed funds minus trailing 1.5% year-over-year change in the core PCE deflator = .75% real Fed funds).

It ain’t too low for my tastes, as I’ve been preaching for a long, long time. ² But I’ve always known that the FOMC consensus was well above me on the notion of the “neutral” real Fed funds rate, so no surprise here in the minutes.

Indeed, the FOMC had declared in its (ridiculously short and formulaic!) statement after the meeting on December 14 that despite its tightening that day to 2.25% for the nominal Fed funds rate, policy was still “accommodative”.

Accordingly, the related paragraph in the minutes of that meeting was akin to an announcement that the sun came up in the east this morning. It did. I saw it, but it wasn’t particularly memorable, ‘cause Mor gan le Fay ³ and I knew it would be coming up from that direction.

Rather, our near-spiritual reaction to the minutes came from two other paragraphs, separately and even more soulfully, together: on global imbalances and excessive risk-taking in financial markets.

First on global imbalances:

“A number of participants voiced concerns about domestic and global financial imbalances. On the domestic front, such concerns focused on the magnitude of current and projected fiscal deficits, which seemed likely to keep national saving low. Views about the prospects for fiscal restraint in the years ahead were mixed; some participants believed that the odds of significant deficit reduction over the next few years were remote while others were more optimistic. Regarding global imbalances and the current account deficit in the United States, a number of participants expressed doubts that such imbalances would be reduced in the near-term. Better global balance would require not only greater national saving in the United States but also a notable strengthening in domestic demand among major trading partners. Such a strengthening seemed unlikely in the near term given the recent softening in the economies of several important industrial countries .” 

Next, on excess risk-taking, the FOMC said:

“In their discussion of financial market conditions, participants noted that investors anticipated further increases in the federal funds rate over the coming year, but intermediate- and long-term interest rates along with financial conditions more generally had remained quite supportive of growth. A few participants commented that the generally low level of interest rates across a wide range of maturities and the recent flattening of the slope of the yield curve (measured as the spread between ten- and two-year Treasury yields) might signal that expectations of longer-term growth had been marked down.

Some participants believed that the prolonged period of policy accommodation had generated a significant degree of liquidity that might be contributing to signs of potentially excessive risk-taking in financial markets evidenced by quite narrow credit spreads, a pickup in initial public offerings, an upturn in mergers and acquisition activity, and anecdotal reports that speculative demands were becoming apparent in the markets for single-family homes and condominiums .”

Theory Meets Shades of Irrational Exuberance
These two paragraphs, together , are the FOMC’s first “official” recognition of the inherent contradiction between:

• Its objective to pursue full employment in the United States in the context of inadequate aggregate demand outside the United States , and  
• Its objective to promote financial market stability – to wit, non-bubble “financial market conditions” –   and, more generally, its objectives as custodian of the global reserve currency, to promote non-bubble global financial market conditions, including most importantly their anchor: “spread markets” in the US of A .

In examining the FOMC’s dilemma, let’s start with the simple observation that in real time, monetary policy can only influence the demand side of the economy, not the supply side of the economy. Put more technically, the supply side of the economy is more or less fixed in real time, so what the Fed can do is influence demand versus that relatively fixed supply, generating changes in resource utilization and thereby, inducing changes in inflation.

Yep, this is how Fed policy works: it’s a Keynesian, Phillips Curve world!

Thus, if employment is less than full employment (a disinflationary influence on wages), the Fed is duty bound to stimulate aggregate demand growth greater than sustainable aggregate supply growth, generating demand for underutilized labor resources. Macroeconomics 101 stuff, here, really; pretty simple stuff.

The dilemma comes in Macroeconomics 102, where we learn that U.S. aggregate demand is more import elastic than is non-U.S. global aggregate demand . Thus, if the Fed seeks to indirectly stimulate job growth in America, by stimulating aggregate demand growth in America, the inevitable – tautological! – outcome will be a larger U.S. trade deficit.

Which brings us to Macroeconomics 103, where we learn that the trade deficit drives the current account deficit, which as a tautology must be financed with a capital account surplus, also known as net foreign investment into the United States.

We further learn that the capital account surplus comprises both private and official foreign net investment in America, and can be in the form of direct investment in tangible assets and investment in both equity and debt instruments.

And finally, in this class, we learn that private investors tend to make their net investment in all three forms, while official institutions tend to be almost exclusively fixed income investors.

Which brings us to Macroeconomics 104, where we learn that private foreign net investment in America is putatively a good thing, while a large share of foreign official investment flows in America’s capital surplus is ostensibly a bad thing. Why?

Foreign private investors in America are theoretically profit-maximizers and are coming to America to make profits, which is a sign that investment in America must be more profitable than in other places.

In contrast, foreign official investors in America are not profit maximizers, and are lending America money as an act of mercantilist self interest , so as to keep their own currencies undervalued, thereby giving their exporters an “unfair” advantage against American producers.

Accordingly, we also learn that the greater the official share of America’s capital account surplus, the more unsustainable it is, and therefore, the more unsustainable America’s current account (or trade) deficit is. Why?

Since foreign official investors are not profit maximizers, there is no assurance they will continue to lend America dollars if and when their non-profit motives change , generating a disorderly decline in the dollar and dollar-denominated asset prices and, therefore, a dark winter for the American economy.

Now, finally, we have the theoretical prerequisites to register for the Senior Seminar, in which we try to apply what we have learned to the real world. And the first thing we learn is that the real world is a lot messier than the textbook world!

In present circumstances, the Fed’s dilemma is either to: (1) downgrade, if not reject, its mandate to foster full employment in America, or (2) pursue that mandate with the virtual certainty of an ever-larger U.S. current account deficit, exposing America to the risk that foreign official investors suddenly decide, for their own non-profit maximizing (political?) reasons, to let a plunging dollar plunge America into a recession (depression?).

Which, of course, would result in the antithesis of the Fed’s mandate to foster full employment in America.

So far, the Fed has chosen to honor its duty to pursue full employment in America, underwriting the risk – repeat, risk! – that foreign official financing of America’s current account deficit becomes less agreeable. I firmly – very firmly! – believe the Fed has made the right choice, even as I respect others that feel differently.

I do not view foreign official investors in America as either strangers or acting out of kindness, but rather people we know who are acting in their own national interest: doing the only thing they can do to support their job creation, unless and until they discover the joys of more robust domestic demand growth.

In contrast, I’ve long worried – much more than most! – about a different risk arising from current global circumstances, in which America must party in order for the world’s party staff to find employment: the risk of asset price bubbles, which ineluctably become asset price busts.

Indeed, I’ve long believed that asset price bubbles are not just a risk, but also a virtual certainty stemming from current global circumstances.

The Fed As Bartender

In order for America to play the role of global aggregate demand partier of first and last resort, in the face of American monetary stimulus leaking out through the current account deficit into foreign job creation, American consumers need to feel good about themselves.

And nothing makes the American consumer feel as good as elevating property prices. Nothing!

House price inflation emboldens consumers to spend liberally out of current income, secure in the knowledge that the house is doing the heavy lifting of wealth building. And for the most animal-spirited of consumers, it allows them to turn their houses into ATM machines.

Accordingly, there is nothing wrong with the Fed offering happy prices for property price tippling, if and when there is a whiff of deflation in the air, borne of irrational ennui. Such was the case in 2001, when the corporate sector checked itself – with a little nudge from the PIMCOs of the world! – into the Betty Ford Center for Balance Sheet Rehabilitation, where job destruction is the order of the day. ⁴

In the wake of that end-of-corporate-denial moment, the American consumer needed some lift to his and her git-along. Job creation wasn’t going to do it. And the Fed provided that lift.

Indeed, on these pages in July 2001, ⁵ I wrote approvingly, declaring that:

“The average American also owns a home. In fact, the home ownership rate in America is at a record high 68%. And while most of those homes are levered, there is room to lever them even more, from both a balance sheet and an income statement perspective. Most important, perhaps, valuation of homes – the price of a home divided by the shelter services that it provides – is secularly cheap.

There is room for the Fed to create a bubble in housing prices, if necessary, to sustain American hedonism. And I think the Fed has the will to do so, even though po litical correctness would demand that Mr. Greenspan deny any such thing (just like he denied belatedly attacking the NASDAQ bubble). So, while I may think Washington needs to put more Keynesian proof in the policy beverage it is serving, there is no question that Washington is pouring from the right decanter.”

Whether or not the Fed has, three and one-half years later, created a bubble in house prices is an open question. At the national level, I think not , as demonstrated by the valuation metric I used back in July 2001, updated on today’s cover.

That said, many regional markets look awfully frothy to me, including the very community in which I live, Newport Beach, California. Far more important than my views, however, the FOMC is now citing property price inflation as a cause of concern !

The last time that Chairman Greenspan allowed publicly that he was concerned about asset price inflation was December 1996, when he rhetorically asked how he (and his colleagues) would know if and when equity valuations had become irrationally exuberant.

As the 1990s drew to a close, with a roaring stock market in his face, he answered his rhetorical question by saying that he could not know if equity valuations were irrationally exuberant, and that bubbles could be identified only after having proven their existence by blowing up.

He further argued that he was not tightening policy to prick an equity bubble, but merely to thwart an unsustainable wealth effect on aggregate demand. I never be lieved Mr. Greenspan’s Mr. Magoo act, and said so publicly, including testimony before Congress. ⁶

I agreed with Mr. Greenspan’s instinct that the equity market was in a bubble, even as he denied that was his instinct. But it was not a generalized bubble, I argued, but rather a bubble in technology stocks, commonly known as New Economy stocks. Indeed, valuations on Old Economy stocks were getting pummeled.

Accordingly, my quarrel with him was that hikes in the Fed funds rate until tech stocks cried uncle was equivalent to “trying to get the attention of gluttons by starving anorexics. It’s bad macroeconomic policy, and it’s also morally wrong.”

I haven’t changed my mind about that. And neither has Mr. Greenspan. But now, in his last year in a great run as chairman since 1987, Mr. Greenspan again puts down a marker: he sees “excessive risk taking.”

To be sure, the minutes did not actually say that Mr. Greenspan sees excessive risk taking, but rather that “some participants” on the FOMC had that concern.

But I think it is safe to say that if Mr. Greenspan didn’t see it, the fact that other FOMC members saw it would not have been recorded in the minutes. Mr. Greenspan lives by words . And if my words here are wrong, I invite him to correct me (as he has time and time again – not in name, but in in-the-face footnotes to his speeches – regarding my advocacy of a hike in margin requirements during the equity market bubble).

Be that as it may, the December 14th FOMC minutes were the stuff of history: the FOMC openly pondering not just goods and services inflation but asset price inflation (risk premium deflation).

And truth be told, I have a lot of sympathy for the FOMC’s concern: the Fed is handicapped by what my colleague Mohamed El-Erian calls “ the insufficiency of active policy instruments.” In this context, Mohamed means fiscal policy : if only the Fed could compel the fiscal authority to apply restraint on aggregate demand, the dilemma of “needing” foreign savings would be diminished.

He’s right!

Dealing With the Rowdy Drunk

For me, however, an even more binding insufficiency of policy instruments is the unwillingness of the Fed to use a regulatory tool to curtail the supply of credit to investors engaged in excessive risk taking , otherwise known as speculators.

Yes, the time has come once again to consider why the Fed refuses to do anything about “excessive risk taking” except to threaten a more nasty upward trajectory for the Fed funds rate ! Regrettably, there is no rational reason to expect the Fed to see things in another way, at least under Alan Greenspan.

In contrast, Fed Governor Bernanke, in his very first speech ⁷ as governor in October 2002, explicitly embraced the validity of using the micro economic tools of regulation, rather than the macro economic tool of the Fed funds rate, in the event of suspected bubble tendencies in select markets.

Specifically, Mr. Bernanke said:

“Another possible indicator of bubbles cited by some authors is the rapid growth of credit, particularly bank credit (Borio and Lowe, 2002). Some of the observed correlation may reflect simply the tendency of both credit and asset prices to rise during economic booms. However, to the extent that credit expansion is indicative of bubbles, I think that empirical linkage points to a better policy approach than attempts at bubble-popping by the central bank . During recent decades, unsustainable increases in asset prices have been associated on a number of occasions with botched financial liberalization, in both emerging-market and industrialized countries. The typical pattern is that lending institutions are given substantially expanded powers that are not matched by a commensurate increase in regulatory supervision (think of the savings and loans in the United States in the 1980s). A situation develops in which institutions can directly or indirectly take speculative positions using funds protected by the deposit insurance safety net – the classic “heads I win, tails you lose” situation.

When this moral hazard is present, credit flows rapidly into inelastically supplied assets, such as real estate. Rapid appreciation is the result, until the inevitable albeit belated regulatory crackdown stops the flow of credit and leads to an asset-price crash. Bubbles of this type may be identifiable to some extent after they have begun, but the right policy is to do the financial deregulation correctly – that is, in a way that does not allow speculative misuse of the safety net – in the first place. Or failing that, to intervene and fix the problem when it is recognized.”

I could not agree with Mr. Bernanke more! The Fed should not use the macro tool of the Fed funds rate to deal with the micro problem of potential bubbles (“excessive risk taking”!) in selected asset markets. That’s why I was so troubled to see the FOMC – or at least “some” of its participants – talking openly in the December 14th minutes about a putative need to get the Fed funds rate up, so as to unwind whiffs of irrational exuberance, borne of a “ prolonged period of policy accommodation.”

The FOMC’s words matter! And they matter all the more now that minutes of FOMC meetings are released before the next FOMC meeting.

The FOMC is what former Fed Vice Chairman Alan Blinder calls an “ autocratically-collegial committee .” ⁸ Professor Blinder defines that label as a committee in which:

“…the chairman more or less dictates the group ‘consensus.’ He may begin the meeting with the decision already made and simply inform the other members. Or he may listen to the debate and then announce the group’s consensus, expecting everyone else to fall in line. But in either case, the group’s decision is essentially the chairman’s decision, hopefully informed by, and perhaps even influenced by, the views of the other committee members. The Federal Open Market Committee under Alan Greenspan is such an autocratically-collegial committee , although Greenspan is a gentle autocrat – meaning that he cajoles rather than browbeats. 

Assuming this characterization of the FOMC is essentially correct, and I have no reason to believe otherwise, I submit that Mr. Greenspan now has a duty to explain publicly as to the degree of concern the FOMC has about “excessive risk taking.”

February’s semi-annual, legislatively-mandated testimony before Congress would be an excellent time!

Maybe, just maybe, he “let” that phrase into the minutes so as to appease hawkish FOMC “participants” (there are 19, but only 12 are “voting members” at any given time), who wanted the FOMC to declare that the “balance of risks” on inflation were tilted to the upside, rather than balanced, as the FOMC actually declared. Surely, in any committee of 19, the chairman has to be a masterful politician, even if an autocratic one.

If so, then last Tuesday is a day that I won’t remember for the rest of my career. To wit, I’m running my roto tiller where there ain’t no dirt. And, indeed, I hope that’s the case .

But hope is a poor excuse for an insurance policy. And when central bankers start musing publicly about asset price inflation (risk premium deflation), asset managers need insurance !

And in the present circumstances, that means getting prepared for an increase in volatility in financial asset prices, both stocks and bonds (and maybe, currencies, too).

Indeed, the most benign interpretation of the FOMC’s intent in mentioning the possibility of “excess risk taking” is that the FOMC – read, Chairman Greenspan – wants to interject some fear into the financial markets .

In fact, over a decade ago, in the earlier stages of the 1994 tightening episode, Mr. Greenspan spoke explicitly about the merits of the Fed injecting uncertainty into the markets as an anti-bubble prophylactic.

At the May 17, 1994 FOMC meeting – as revealed in the verbatim transcript of that meeting, not the minutes! Transcripts are released only with a five-year lag – Mr. Greenspan opined:

“The issue of uncertainty as being helpful or unhelpful is really not clear-cut. We experienced periods of relative certainty in the latter part of 1993 which everybody just looked at as though the markets had no downside price risks; everyone was committed. The yield spreads were very marginal, and indeed they had all been coming down dramatically from the 1987 peaks after the stock market crash, and there was an element of euphoria that really gripped the markets. 

You could see that in huge increases in mutual funds, both stock and bond funds. In fact, what we were dealing with largely was a situation in which there was very little uncertainty. That clearly was a very unhappy state of affairs; the mere fact that uncertainty did not exist was not a good; it clearly was a bad. And our endeavor to break that pattern, which we had to do even though it turned out to be a much bigger problem than we suspected, was a very purposeful endeavor to create a degree of uncertainty and readjust holdings from weak hands into firmer hands as far as speculative securities are concerned. As a consequence we have taken a very significant amount of air out
of the bubble.”

That was long before December 1996, of course, when Mr. Greenspan uttered the words “irrational exuberance.” Accordingly, perhaps we shouldn’t make too much of Mr. Greenspan’s ode to the wonder working power of uncertainty .

But perhaps we shouldn’t make too little of it, either! What we do know is that Mr. Greenspan, unlike Mr. Bernanke, has no taste whatsoever for applying micro regulatory solutions to micro bubble problems.

Or to return to an analogy I used last summer, ⁹ if Mr. Greenspan were a bartender with one rowdy drunk:

He would double the price of beer for all, in an effort to bankrupt the drunk more quickly, rather than simply cut off the drunk, letting the decent folk continue
to act decently at an unchanged price. 

I firmly believe that the welfare-maximizing policy for society would be to cut off the drunk. But I don’t run America’s monetary policy. Mr. Greenspan is the monopolist bartender, not me.

Accordingly, if he wants to endeavor (one of his favorite words!) to engender uncertainty, otherwise known as fear, in the minds, hearts and wallets of those engaged in “excessive risk taking,” all of us , not just those engaged in excessive risk taking, should get a firm grip on our wallets.

Or, to return to my analogy, we should take a walk ‘round the block, until the rowdy drunk falls off his stool.

Bottom Line

This counsel applies most importantly to exposure to the “high-beta” asset classes: they are the rowdy drunks, most egregiously, the U.S. corporate bond market.

Not that U.S. corporate credit fundamentals have not improved. They have, tremen dously! Indeed, if that were not the case, we wouldn’t even be thinking about “excessive risk taking” in credit securities: history demonstrates that you simply don’t get speculation without a positive fundamental spark .

History also teaches, however, that speculative fires, once sparked by positive fundamentals, tend to flame into overshoots of fair-value fundamentals. Or, as Mae West once said, if a little is good and more is better, then way too much is just about right.

Until, of course, just about right is revealed to be too much, as the marginal buyer falls off his and her barstool. Thus, on corporate bonds, the FOMC’s message is clear: ‘tis a time for temperance!

The same holds for emerging market bonds, with the caveat of moderation in all things, including moderation

And how about overall interest rate risk, also known as duration; exposure to the slope of the yield curve; and exposure to volatility, also known as negative convexity?

Actually, these are much tougher calls than the credit call, because wider credit spreads are putatively the intermediate objective of the Fed’s disquiet, making it easy to say that credit spreads have only one way to go. ¹⁰

In contrast, a volatile bear flattening of the real yield curve would be only a macro means for the FOMC to induce a nasty correction in credit spreads, with the realization of such a correction leading to a less volatile, bullish re-steepening of the real yield curve.

Thus, in response to the FOMC’s not-so-veiled threat at “excessive risk taking,” temperance is warranted in the short run on duration, yield curve and volatility exposures.

But only in the short run. If and when the FOMC “succeeds” in injecting uncertainty and fear into financial market participants’ risk appetites, it will be time to once again become risk seeking.

Between now and then, circumspect investors should take solace in the dictum that pleasure is sometimes about avoiding pain.

Cash ain’t always trash. It doesn’t yield much, though over twice what it did a year ago. And it has the uniquely redeeming characteristic of always trading at par.

Paul McCulley

Managing Director
January 11, 2005

¹ For the record, this is the first time the FOMC has officially called it a “target!”