*  This essay was the foundation for a speech delivered to the Bank Credit Analysts’ 
New York Conference on November 17, 2003

In one sense, the bond market outlook for 2004 is easy: it will be a year of investors living constantly in fear of tighter Fed policy. Such fears may or may not be realized. I think not. But in many respects, whether the fears are realized or not doesn’t really matter all that much; the fears themselves will be the straws that stir the fixed income drink.

The drink itself will be a cocktail of:

• Upside cyclical growth rhythm in the context of
• The Fed’s secular achievement of “effective price stability,” in the context of
• A below-equilibrium level – both nominal and real – for the Fed funds rate.

   

Let’s look at each of these ingredients individually, and then shake them vigorously. Before doing so, however, let me serve you my conclusion: by the end of 2005, the Fed will have tightened by 1½ percentage points to 2½% for Fed funds. Note I said that the Fed will have “tightened,” not that the Fed will have “removed accommodation.”

With all due respect to San Francisco Fed President Robert Parry, the beginning of a rate-hiking campaign is the beginning of a tightening campaign, not the beginning of a removal-of-accommodation campaign. The moment that the Fed hikes the Fed funds rate the first time, investors will immediately seek to price the forward curve for Fed funds for the timing and level of the last hike. Just like President Clinton could not convince the public that he didn’t really smoke pot since he didn’t inhale, the Fed will not be able to convince the fixed income market that tightening isn’t really tightening.

The turn of the Fed rate cycle to tightening, even if likely only after a “considerable period,” will beget wholesale changes in risk premiums across a wide array of financial asset prices, with various parts of the fixed income market being the relative stars and goats of the show. Most fundamentally, the turn to tightening will require investors with an absolute return objective to increase emphasis on capital preservation, with reduced emphasis on yield enhancement through leverage. And for investors with a relative-to-benchmark objective , the turn to tightening will require a passion for carry, to mitigate somewhat the yield give up of below-benchmark durations. I’ll come back to that conclusion in a bit, but first let’s examine the fundamental ingredients in the fixed income cocktail for 2004.

Winning the Peace of Price Stability
The Fed’s secular war against inflation, commenced by Paul Volcker on October 6, 1979 , is over. I’m not sure I can pinpoint the day the war ended, but I can pinpoint the process of the Fed declaring victory. The armistice dance started November 13, 2002 . The FOMC had just cut the Fed funds rate a surprisingly large (to consensus) 50 basis points on November 6, and Chairman Greenspan was testifying before Congress on the whys and wherefores. In question period, he explicitly addressed the risk of deflation and the Fed’s power to prevent/arrest it, declaring:

“There is an implication in the notion (of fighting deflation risks) that we are restricted to overnight funds. But our history as an institution indicates that there have been innumerable occasions when we have moved out from short-term issues and invested in long-term Treasuries. We do have the capability, if required to do so, to go well beyond activities related to short-term rates.”

That, my friends, marked the beginning of the official end of the war against inflation, and the beginning of a new campaign to win the peace of “price stability.” A little over a week later, (then new) Fed Governor Bernanke shouted an elegant amen, declaring:

“…the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”

And then finally, on May 6, 2003 , six months later and just over six months ago, the FOMC, speaking as a body, unveiled the memorial in honor of the end of the war against inflation, declaring:

“Although the timing and extent of that improvement remain uncertain, the Committee perceives that over the next few quarters the upside and downside risks to the attainment of sustainable growth are roughly equal. In contrast, over the same period, the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level. The Committee believes that, taken together, the balance of risks to achieving its goals is weighted toward weakness over the foreseeable future.”

Along with marking the end of the war against inflation, the FOMC’s May 6 declaration also marked the death of the doctrine of preemptive tightening, a key cyclical weapon in the Fed’s secular “opportunistic disinflation” campaign. That strategy involved “taking recessions” with equanimity whenever fate begot them (perhaps with a helping hand of Fed tightening). The resulting opening of the output gap (people losing their jobs!) would pay “opportunistic” disinflationary dividends, which would then be “locked in” during the subsequent recovery via preemptive tightening, preventing the output gap from closing too quickly and/or fully at all. The raison d’etre of that secular strategy was that there was always a lower rate of inflation the Fed wanted to achieve, cycle by cycle on the journey to the promised land of “effective price stability.”

The recession engendered by the bursting of the triple bubbles of the late 1990s – in equity valuation, in business investment and in corporate leverage – marked the last “opportunistic” battle of the secular war against inflation. Or, as Governor Bernanke declared on July 23, 2003 :

“Since the inflation crisis of the 1970s, the Federal Reserve has consistently pursued the goal of price stability in the United States . And not too long ago, something remarkable happened – the goal was achie ved!”

Mr. Bernanke went on to say:

“….we are now i n a situation in which risks to the inflation rate can be either upward, toward excessive inflation, or downward, toward too-low inflation or deflation. As many of you are aware, the Federal Reserve officially recognized this new situation in its balance-of-risks statement issued at the close of the FOMC meeting this past May 6. That statement was the first to assess the risks to economic activity and inflation separately, recognizing explicitly that upside and downside risk to inflation could exist under varying conditions of the real economy. Previous FOMC statements had characterized the balance of risks one-dimensionally, as being either in the direction of economic weakness or in the direction of excessive inflation. The May 6 statement was more than a procedural innovation; it also broke new ground as the first occasion in which the FOMC expressed the concern that inflation might actually fall t oo low.”

The FOMC broke additional new ground at its August 12 meeting, when the Committee linked its fear of excessively low inflation to a commitment to eschew the preemptive tightening tactic employed during the war against inflation. Specifically, the FOMC said:

“The Committee p erceives 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 pe riod.”

Ah, the magic words: “a considerable period”! Ever since they were uttered on August 12, and repeated on September 16 and October 28, fixed income market participants have focused on little else: how long is a “considerable period”!??!? The truth of the matter is that I don’t know, and I further believe that most FOMC members do not know.

In point of fact, I don’t think the FOMC should have ever uttered those “considerable period” words. As Goldman Sachs’ Bill Dudley and I wrote on April 24 in the Financial Time s 1 :

“…the Fed should commit to keeping its Federal Funds rate at or below the current 1 per cent until core inflation climbs back to, say, 2 per cent or higher on a year-on-year basis. The current reading of about 1 per cent (on Mr. Greenspan’s preferred measure, the core PCE deflator) is right in the middle of the 1-2 per cent range that Ben Bernanke, Fed governor, recently suggested as the working definition of price stability.

A commitment to a higher inflation rate would be better than a commitment to eschew tightening for a specific period, as some have suggested.

In contrast, a time commitment could backfire. If the economy were much stronger than expected and inflation climbed, Fed officials would be stuck with a Hobson’s choice – honor the commitment and allow inflation to climb higher than desired or renege on it and lose years of hard-won credibility.

A strategy tied to an objective of modestly higher inflation does not require an accurate forecast. The Fed just has to be willing to live with inflation as high as the target. But what about the danger of an economy with a head of steam overshooting the inflation target? After all, given the slow effect of monetary policy, it would take time for the Fed to slow the economy.

This is a risk. But we have little doubt that the market would start to raise longer-term interest rates, tightening long before the Fed. Meanwhile, the Fed would restore a buffer of inflation against a deflationary shock.”

The FOMC clearly didn’t read our essay, or did and didn’t agree, as the Committee embraced a (vague!) time commitment for accommodation, rather than a commitment linked to an inflation exit strategy. As Bill and I warned, this time commitment is now running up the collective FOMC pant leg like an army of carpenter ants. I think the FOMC will soon want to extricate itself from this self-inflicted agony, dropping the “considerable period” rhetoric and replacing it with language that is more fundamentally grounded.

Indeed, on November 6, 2003 , Chairman Greenspan cleverly didn’t use the words “a considerable period” but rather finally – finally! – conducted a proper funeral for both the secular strategy of “opportunistic disinflation” and the cyclical tactic of preemptive tightening. Specifically, he said:

“A critical factor distinguishing the current economic environment from much of the previous experience of the past half-century is the inflation backdrop. In previous recessions since the 1960s, the underlying rate of inflation at economic troughs remained clearly above any level that could be associated with effective price stability. As a consequence, with some risk to economic activity, monetary policy typically had to move aggressively in the uncertain early stages of past economic recoveries to ensure that inflation would be contained.

By contrast, in the current episode, core consumer price inflation as measured in the national income and product accounts has been running only a little more than 1 percent over the last year, and firms exhibit scant evidence that they are gaining appreciable pricing power despite the pickup in the pace of economic growth. Indeed, the Federal Open Market Committee has judged that the probability, though minor, of an unwelcome fall in inflation exceeds that of a rise in inflation from its already low level. In these circumstances, monetary policy is able to be more patient. That said, no central bank can ever afford to be less than vigilant about the prospects for inflation.”

Patient, he said. The FOMC will be patient! Which, of course, leads the wiseacres amongst you to ask: will the FOMC be patient for a considerable period; and if so, just how long is a considerable period? My answer: until the unemployment rate is well below 5% and the core PCE deflator is 2% or higher. I expect those conditions to be met in 2005; but not 2004. More about this forecast in a moment. Bottom line: I believe the most important ingredient in the fixed income outlook is that the FOMC is now waging a campaign to win the peace of price stability, not an opportunistic war against inflation. The doctrine of preemptive cyclical tightening is dead!

The Output Gap Rules (Until It Doesn’t)
The FOMC uses a host of models to forecast inflation on a cyclical horizon. The dominant model is, however, the old fashioned (expectations-augmented) Phillips Curve, which represents nothing more than the trade-off between resource utilization and pricing power. Or, for those of us with gray hair, or none at all, this is the trade off between unemployment and inflation: the higher the unemployment rate, the more docile will be labor’s wage demands; and vice versa.

For the sake of analytical rigor (and political cover!), the Fed doesn’t talk about the utilization rate for labor by itself, but rather the utilization rate for both labor and non-labor resources, summarized nicely at full utilization in the concept of potential GDP . It’s a robust concept, even if terribly difficult to calculate: it captures the growth potential inherent in labor force expansion and capital formation, as well as the scope for increased productivity of both labor and capital, separately and together in something called total factor productivity.

With the concept of potential GDP , we can contemplate something called the “output gap” – the difference between potential GDP and actual GDP . A lot of researchers have burned a lot of midnight oil and computer time trying to calculate the thing – the full employment act for economists, I suppose. At the end of the day, however, practical people always translate estimates of the output gap into an unemployment gap using something called Okun’s Law – which posits that there is a 2-to-1 ratio between the output gap and the unemployment gap, defined as the difference between the NAIRU (the non-accelerating inflation rate of unemployment) and the actual unemployment rate. To wit, a 2% output gap implies a 1% unemployment gap.

In fact, many analysts – and I admit to doing this myself sometimes – start with a visceral sense of the unemployment gap and use Okun’s Law to estimate the output gap. I suspect that more than a few FOMC members do the same thing!

Indeed, Governor Bernanke ran his analytical roto tiller in precisely this soil this summer. In the same July 23 speech I’ve already noted, he ruminated:

“By conventional analyses, therefore, even if the pace of real activity picks up considerably this year and next, persistent slack might result in continuing disinflation.

A highly simplified, though not quantitatively unreasonable, calculation may help. Let us suppose that economic activity does pick up in the second half of this year, by enough to bring real GDP growth in line with its long-run potential growth rate – roughly 3 percent or so, by conventional estimates. Moreover, suppose that activity strengthens further next year so that real GDP growth climbs to approximately 4 percent, a full percentage point above potential. What will happen to resource utilization and inflation?

Focusing first on the implications for economic slack, we note that this projected path for real GDP gap would imply no change in the output gap through the end of this year, followed by a percentage point reduction in the output gap during 2004. Given the average historical relationship between the change in the output gap and labor market conditions, known as Okun’s Law, the unemployment rate would be expected to remain at about its current level of 6.4 percent through the end of the year and then decline gradually to about 6.0 percent by the end of next year. This projection is fairly close to many private-sector forecasts.

Let us turn now to the implications for inflation. From 1994 to 2002, core PCE inflation remained in a stable range while the unemployment rate averaged about 5 percent; so let us suppose, for purposes of this example, that the unemployment rate at which inflation is stable is 5 percent. (If the unemployment rate at which inflation is stable is lower than 5 percent, the disinflation problem I am discussing becomes larger.) A little arithmetic shows that this scenario involves 1.9 point-years of extra unemployment (relative to the full-employment benchmark) between now and the end of 2004. Now make the additional assumption that the sacrifice ratio (the point-years of unemployment required to reduce inflation by 1 point) is 4.0, a high value by historical standards but one in the range of many current estimates. Then the additional disinflation between now and the end of next year should be about 1.9 divided by 4, or about 0.5 percentage points. So given our assumptions about GDP growth, core PCE inflation, say, might fall from 1.2 percent currently to 0.7 percent or so by the end of 2004.

The precise figures I have used in this exercise should be taken with more than a few grains of salt. But the bottom line (which would not be much affected if we played around with the numbers) is that, even if the economy recovers smartly for the rest of this year and next, the ongoing slack in the economy may still lead to continuing disinflation. So the FOMC’s May 6 statement, by indicating both balanced risks to economic growth (that is, a reasonable chance of a good recovery) and a downward risk to inflation, had no internal inconsistency.”

Yes, the FOMC does indeed have the room to be “patient,” as Mr. Greenspan vowed two weeks ago. I believe he will be a man of his – and the FOMC’s – word: the next cyclical tightening campaign will not start until closing of the output gap is well advanced. Put differently, the next tightening campaign will not start until the unemployment rate is approaching the FOMC’s putative NAIRU estimate of 5%, with supporting evidence provided by a pick up in the year-over-year increase in core inflation measures. This means, by Okun’s Law, that real GDP growth of 4% next year is not a problem for the FOMC to solve, but rather a forecast that the FOMC should pray comes right.

We now have two of the three ingredients for the 2004 fixed income cocktail: the FOMC’s new secular goal of nurturing price stability and the FOMC’s associated cyclical goal of remaining accommodative until the output gap closes, so as to reduce the risk of “unwelcome” further disinflation. Now to the third ingredient, which is the most devilish for me (and probably the FOMC, too): today’s starting point level for the Fed funds of 1%.

What the Sam Hill is Equilibrium?
Some economic concepts need to be modeled in order to be properly understood. Others do not. One of the others is a one percent Fed funds rate. The visceral computers embedded in the pit of our bellies tell us that one percent is just too damn low. It’s the same chip that tells me, and maybe you, that portions at fine French restaurants are just too damn small. We are where we are on the Fed funds rate not because the Fed planned to take us here, but rather because of a sequence of unforeseen events that “forced” the Fed to take us here.

Foremost in this regard were the Tragedy of September 11, 2001 , the Revealed Sins of Corporate Malfeasance of 2002, and the Preemptive War in Search of WMDs in Iraq of 2003. All three shocks undermined capitalists’ risk-seeking mojo, acting as headwinds to recovery in corporate investment and employment. These developments “forced” the Fed to stoke unbridled consumer enthusiasm by taking rates sufficiently low to let households turn their houses into ATMs (a process that Mr. Greenspan euphemistically dubbed “equity extraction” several years ago).

With the corporate sector now emerging from the Betty Ford Center for Balance Sheet Rehabilitation – a forced visit after the bursting of the bubbles of the late 1990s – it is tempting to forecast Fed tightening simply to get the Fed funds rate back up to a more “normal” level – the proverbial “take back” of emergency-driven easing. And I’m quite sure that more than a few FOMC members have that urge, kinda like the urge to put on a neck tie when going to church – simply the right thing to do, and all that.

There are two tricky things about this line of thinking, however. First, history demonstrates that changes in the Fed funds rate, not the level of the Fed funds rate, drive cyclical changes in aggregate demand growth. Levels matter, to be sure, particularly the level that puts homeowners’ refinancing options into the money. Such was the case this spring, when the anticipation of a downward change in the Fed funds rate – and maybe “unconventional” easing! – took the level of open market rates sufficiently low to allow all but the dead to refinance their mortgages (and to extract equity, if they were so inclined). But once the household sector has responded to a new lower level of rates, that level is no longer a source of stimulus. Or, as I like to say ‘round the shop in Newport Beach , you don’t get to go to (aggregate demand) heaven twice for the same good Fed easing deed.

Thus, for the Fed to hike the Fed funds rate because it appears the rate is too low would not be simply a matter of “taking back easing.” The Fed can’t take back easing, if easing worked its magic by triggering a one-off refinancing of mortgages. In this regard, the Fed really can’t go home again. Bottom line: there is no cyclically “neutral” level for the Fed funds rate, if the Fed keeps changing it, because the cyclical course of aggregate demand is constantly responding to the prior change!

Accordingly, I see no reason for the Fed to commence a tightening campaign, simply because the current Fed funds rate is too low. It is indeed too low, I think, but that itself is not a sufficient condition for hiking it. The sufficient conditions are, as I’ve already discussed, unemployment approaching NAIRU and inflation rising to the top of the FOMC’s implicit target zone.

That said, the current level of the Fed funds rate does matter when thinking about how far the Fed’s tightening campaign will go, once it starts. On this score, I put my cards on the table in the August Fed Focu s 2 , positing:

“The Fed funds rate is the return on money, which has zero default risk and zero price
risk: a buck is a buck is a buck. In contrast, private sector credit carries both default risk and price risk. Thus, I believe that the ‘equilibrium’ real short rate should not be equal to Taylor ’s putative 2%, but rather equal to the economy-wide marginal income tax times the Fed’s inflation target.

Money should pay a sufficient interest rate to make holders of money whole for two taxes: the explicit tax 3  on nominal interest income and the implicit tax of inflation. But money should not pay a real after-tax rate of return. In the long run, the economy can ‘afford’ to pay a real return only on capital that is at risk.

Thus, I don’t buy that the ‘neutral’ Fed funds rate should be 4% if unemployment is at 5% and inflation is at 2%, as suggested by Taylor ’s Rule. Rather, I think the ‘neutral’ Fed funds rate should be (1+ .2%) times the Fed’s 2% inflation target.”

Ergo, my magic number for the “neutral” nominal Fed funds is 1.2 x 2% = 2.4%. But no need for artificial precision here. Let’s call it 2½%, in a range of 2%-3%.

Shake and Pour
With all three of our fundamental fixed income market ingredients now in the shaker, it is time to shake it.

• The Fed’s new secular objective of winning the peace of price stability tells us that the doctrine of preemptive tightening is dead.
  
• The economy’s current output gap tells us that downward pressure on the inflation rate is more likely than upward pressure, until the unemployment rate falls appreciably, which will require a year or more of 4% growth.
  
• And finally, the prevailing 1% Fed funds rate is about 1 percentage points “too low” on an “equalibrium” basis.  

The cocktail, now pouring into your glass, is a 2½% Fed funds rate by the end of 2005. The straw in the beverage in 2004 will be fear, both as to how we the markets discount 2005 and how we the people choose our nation’s president for 2005 and beyond.

My best guess is that by the end of 2004, two-year Treasuries will be flirting with 3%, 5-year Treasuries will be hanging out with 4%; and 10-year Treasuries will be romancing 5%.

At which time, it will be time to extend durations again. Between now and then, absolute return investors should learn to appreciate cash, which doesn’t yield much, but has the uniquely redeeming characteristic of always trading at par. And relative return investors should be willing to make a wager against the Fed funds forward curve – yes, the carry trade – if and when it is discounting too much Fed tightening too quickly.

Next year will not be a fun year for the fixed income markets. It will be a year in which pleasure will be about avoiding pain.

Paul McCulley
Managing Director
November 10, 2003
mcculley@pimco.com

¹ http://news.ft.com/servlet/ContentServer?pagename=FT.com/StoryFTFullStory&c=StoryFT&cid=1048313970428&p=1012571727088

²  "Needed: Central Bankers With Far Away Eyes," Fed Focus, August 2003.

³ I use 20% as an estimate for the economy-wide marginal income tax rate; if anything, this is to high.