The older we get, the more milestones seem to matter. Whether that’s a sign of maturity or merely a reflection of getting older, I don’t know. In any event, this month marks the twelfth edition of Fed Focus, a year of sounding off in the glare of comparison to Bill Gross’ Investment Outlook. He has always been a gentleman about any differences of opinion we’ve had, encouraging me to follow my research wherever it may lead. I give him an early look at my missives, and only once has he offered a nudging word of criticism. And on that occasion, it had nothing to do with macroeconomic substance. Rather, he suggested that I find a substitute for the word “paroxysmal,” since he really didn’t know what it meant, and besides, it sounded “a little heavy.”

I naturally dropped the word, but since I just used it, I get the last laugh (not!). Seriously, it has been fun talking to you monthly over the last year, and I look forward to many more years of doing the same. We believe strongly here at PIMCO that macroeconomic ideas matter, and matter hugely in the formulation of investment strategies. We also believe strongly that nobody has a monopoly on forecasting the likely course of the New Economy in the years ahead.

In the midst of private sector-driven macroeconomic revolution, which is really what the New Economy is about, old models of macroeconomic and financial relationships break down. This change demands that policy makers and investment managers undergo a similar revolution in their thinking. Such thinking anew must, however, be grounded in sound macroeconomic and financial theory. In some instances, theory itself is being re-written by the New Economy. In far more instances, however, what is happening is that old theory still applies, but the empirical application of that theory is simply being redefined by the New Economy.

Limits on the Disciplinarian’s Limits

This is nowhere more true than in the formulation of Federal Reserve policy. Three key issues are in play: (1) the supply of labor and the associated natural rate of unemployment; (2) the secular growth rate of productivity; and (3) the systemic stability of the financial system. All three issues are about limits, about statism versus entrepreneurship .

The public’s wants are (almost) always greater than the economy’s ability to provide and, in a democracy, the public quite naturally, and rationally, votes for politicians that promise more for less. The politicians, to their credit, recognize that their own self-interested (not craven!) tendencies make them unsuited for the job of monetary policy, which has the power to create money out of thin air, an inflationary powder keg. Accordingly, the politicians delegate monetary policy to the independent Federal Reserve, to protect them from themselves (alternatively, to protect us from ourselves!).  

Can Productivity Keep Accelerating If Demands Slows?

Figure 1
Source: U.S. Commerce Dept., U.S. Labor Dept.

In this set-up, the Fed becomes the designator disciplinarian, charged with limiting fulfillment of the public’s demands to the economy’s capacity to supply them in a non-inflationary manner, on both Main Street and Wall Street. If Main Street demand is growing faster than supply, pushing up capacity utilization rates for labor and tangible capital, putting upward pressure on inflation, the Fed is supposed to apply the disciplinary rod of interest rate hikes. Alternatively, if demand is growing slower than supply, lowering capacity utilization rates for labor and tangible capital, fostering disinflation, the Fed is supposed to offer the reward of interest rate cuts. Likewise, if Main Street’s demand for credit is growing faster than its supply of savings, the Fed is supposed to tighten the regulatory screws on banks’ (and thus, Wall Street’s) ability to create credit.

As a practical matter, this disciplinarian mission properly makes the Fed risk-adverse. It also makes the Fed backward-looking; limits on job creation, growth and financial system risk are defined on the basis of what history suggests is “prudent.” In a static world, this backward-looking Fed modus operandi would not be a problem. In an entrepreneurial world, with positive productivity shocks, however, the Fed’s bias toward believing that “past performance is indicative of the limits of potential future performance” is an anti-populist ball and chain. It is also, in a de-regulated banking world in which the Fed’s regulatory screws have been un-screwed, a prescription for credit-financed speculation, notably in equities.

This simple dialectic has troubled me for many years: The Fed’s unwillingness to give the benefit of the doubt to a positive productivity shock on Main Street, alongside its unwillingness to raise a doubt about the possibility of a speculative bubble on Wall Street. Yes, my populist roots run long and deep! Since the introduction of Fed Focus a year ago, my visceral distaste for the Fed’s anti-populist bias has become ever more explicit, as well as my public criticism of the Fed. More specifically, I have openly busted the Fed’s chops, including testimony before Congress, for (1) tightening with the explicit objective of thwarting job creation and real wages; 1 while (2) steadfastly refusing to acknowledge speculative tendencies in stocks, either directly by hiking margin requirements, or indirectly by explicitly linking tightening action to frothy stocks. 2

Fighting With the Nattering Nabobs

My most strident criticism has been reserved for the Fed’s Nattering Nabobs of a 5%+ NAIRU (non-accelerating inflation rate of unemployment), led by Fed Governor Larry Meyer. This wing of the Fed has made no secret over the last year about its desire to tighten “sufficiently” to drive the unemployment rate up one percentage point or more from the current 4%, throwing some 1 ½ million Americans out of work (or alternatively, preventing the same number from getting a job over time, as they enter the labor force).

As I demonstrated in empirical detail two months ago, 3 if the Fed were to wrap itself around a 5%+ NAIRU axel, conventional (backward-looking) rules of thumb would imply a “need” to hike Fed funds to a recession-inducing 8%. In contrast, if 4 ½% unemployment was actually consistent with non-accelerating inflation, implying a “need” to drive unemployment up “only” one-half percentage point, those same rules of thumb would imply that the prevailing 6 ½% Fed funds rate was just right. And finally, if the New Economy NAIRU was actually 4%, in line with its actual rate, conventional rules would imply an eventual “need” for the Fed to ease to 5 ½% Fed funds, in order to get to a “neutral” setting.

Historically, Fed Chairman Greenspan has religiously avoided giving a personal assessment as to his estimate of NAIRU, even as he has openly led the FOMC in aggressive tightening action, which the FOMC openly linked to thwarting falling unemployment. Seemingly, harking back to his Nixon/Ford days, he has steadfastly maintained “plausible deniably” that he, personally, wanted to drive up the unemployment rate.

Thus, it was my most fervent hope going into Greenspan’s July semi-annual congressional testimony (formerly known as Humphrey Hawkins, and now known as formerly what was known as Humphrey Hawkins!), that he would be man enough to come clean on his estimate of the NAIRU. In fact, I offered last month in this space both the hubcaps and the bud vase from my VW Beetle, if Greenspan would quit obfuscating about whether he thought 4% unemployment was “too low.”

Well, lo and behold, and as a man of my word, I owe Mr. Greenspan some Beetle accoutrements! The following dialogue with Senators Mack and Bayh was the sweetest of sweet music to my principled populist ears:  

 

MACK: I want to focus on the issue I seem to always focus on and that’s the issue of price stability and inflation. Some people believe that the unemployment rate needs to go to 5 percent in order to prevent inflation. I guess that’s referred to as a so-called NAIRU theory. We’re presently at 4 percent, so that would mean we’d have to, over time, see the unemployment rate rise back to 5 percent. I’ve gone back and looked since the 1940s, and every single time that we’ve had an unemployment rate go up by 1 percent, whether that was over a one-year period, two-year period, three-year period, four-year period, we’ve had a recession. So, you know, that theory concerns me. And I guess my question is, in your view, can we achieve price stability with employment at 4 percent or do we need to move the unemployment rate back higher in order to achieve price stability?

GREENSPAN: I think the evidence indicating that we need to raise the unemployment rate to stabilize prices 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, at least in anywhere near as useful indicator, as it was through perhaps a 20-year period up until fairly recently.

MACK: Is the question-and-answer sessions of the chairman with the Congress made available to the other members of the Federal Open Market Committee?

GREENSPAN: They are in the public record, and if you want to...

MACK: I would think it would be helpful if it were made available to the other members of the Open Market.

BAYH: Well, let me just — more specific, I think at the beginning you started to address the question, and I gathered 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.

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 on either side of this question is not yet of sufficient persuasiveness to convince everybody.

 

He said it! While pooh-poohing NAIRU as a useful analytical tool, Greenspan said that “I suspect, yes,” the Fed can maintain price stability with a 4% unemployment rate. That’s about as close to declaring victory on the tightening campaign of the last year as Mr. Greenspan could come. Mr. Greenspan simply doesn’t have further tightening on his mind. The less fortunate among us, who are working and aspiring to the American dream for the first time in their lives, will be allowed to keep or get jobs!

Greenspan Sees My Ante and Ups Me!

Indeed, Greenspan saw my 4% NAIRU ante, and actually upped me on the issue of secular productivity growth potential in the New Economy. As I laid out in theoretical detail last month, 4 the lesson of history is that a successful Fed campaign to slow aggregate demand will also slow productivity growth, pushing up unit labor costs and generating a cyclical interregnum of something that smells like stagflation. Mr. Greenspan acknowledged this historical “model” of cyclical productivity behavior, but very uncharacteristically for a central banker, entertained the possibility of a much more pleasant, “this time is different” outcome.  

 

“In one sense, the more important question for the longer-term economic outlook is the extent of any productivity slowdown that might accompany a more subdued pace of production and consumer spending, should it persist. The behavior of productivity under such circumstances will be a revealing test of just how much of the rapid growth of productivity in recent years has represented structural change as distinct from cyclical aberrations and, hence, how truly different the developments of the past five years have been. At issue is how much of the current downshift in our overall economic growth rate can be accounted for by reduced growth in output per hour and how much by slowed increases in hours.

So far there is little evidence to undermine the notion that most of the productivity increase of recent years has been structural and that structural productivity may still be accelerating. For the moment, the drop-off in overall economic growth to date appears about matched by reduced growth in hours, suggesting continued strength in growth in output per hour. The increase of production worker hours from March through June, for example, was at an annual rate of  ½ percent compared with 3 ¼ percent the previous three months. Of course, we do not have comprehensive measures of output on a monthly basis, but available data suggest a roughly comparable deceleration.

A lower overall rate of economic growth that did not carry with it a significant deterioration in productivity growth obviously would be a desirable outcome. It could conceivably slow or even bring to a halt the deterioration in the balance of overall demand and potential supply in our economy.”

“Wow!” I exclaimed to PIMCO portfolio managers sitting ‘round me as Greenspan uttered these words. He is arithmetically correct that if demand and hours slow together, there need not be any slowdown in productivity, or acceleration in unit labor costs. But historically, it has never cyclically unfolded that way, as shown in figure 1, for the simple reason that employers don’t immediately cut hours worked when demand slows, just like they don’t immediately lengthen them when demand unexpectedly accelerates.

To be sure, hours did slow more than tick-for-tick with demand in the just completed quarter. I doubt, however, that this is the beginning of a “this time is different” cyclical outcome for productivity, because it would require a fundamental change in the human nature of employers. But what the hey, for one quarter at least, Greenspan is right! More important, the fact that Mr. Greenspan is willing to think out loud about this possibility speaks volumes about his conversion to New Economy thinking. After all, this is the same man who derisively declared in February 1997 that “history is strewn with visions of ‘new eras’ that, in the end, have proven to be a mirage.” His mere musing about the possibility of a repeal of the cyclicality of productivity underscores just how deep-seated his New Economy bias has become.

The Year Ahead

While Fed Focus is devoted to Fed watching, which has been appropriate over the last year, I have a hunch that I’ll actually be talking less about monetary policy, and more about fiscal policy over the next year. After all, now that Mr. Greenspan has told Governor Meyer to take a long walk on a short (low!) NAIRU pier, I don’t have a lot to get worked up about on the monetary policy front. In contrast, it would seem only appropriate for me to start talking more about fiscal policy, because that’s all Congressmen seem to want Greenspan to speak about! And rationally so, because he is an advocate of high and rising fiscal surpluses, while opining that should surpluses “become politically infeasible to defend,” tax cuts should take priority over spending initiatives.

I submit that high and rising surpluses are, in fact, becoming “politically infeasible to defend.” The public simply does not buy permanently wearing a hair shirt of fiscal austerity in a world of permanent fiscal surpluses. I also submit that it is beyond Mr. Greenspan’s policy brief to declare that tax cuts should take priority over spending initiatives. The last time I checked, that’s a matter for the democratic process to decide. Indeed, since I’m a Democrat and Bill Gross is a Republican, we probably disagree personally on the issue of how surpluses should be used. But I have no doubt that he and I agree this is an issue “for the people to decide!”

But perhaps I protest too loudly. Principled populism has finally come to monetary policy, and it seems set to come to fiscal policy, even if under the label of compassionate conservatism.

I’ll take it any way I can get it!

Paul McCulley
Executive Vice President
August 7, 2000 M
paul.mcculley@pimco.com

1 “Skip The Fed Fandango,” Fed Focus, December 6, 1999

2 “Fly Fishing In A Deli,” Fed Focus, March 1, 2000

3 “NAIRU’s Valentine,” Fed Focus, June 1, 2000

4 “Playing Solitaire With A Deck Of 51,” Fed Focus, July 1, 2000

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