There’s an ugly rumor going round that you recently gave a speech in Switzerland asking the Fed to lay more rules on the market -

I am trying to do these days is be the first to lay out the parameters of this new world the Fed is operating in. The most important one of which is Yes, of course, they have to cyclically respond to inflation. But in the context of trying to win the peace of price stability, as opposed to the way they operated during the long war against inflation. My intellectual interest is figuring out how this new world works, now that the war against inflation has been won. The Fed is feeling its way in this new world of price stability, which is fine. But I would like to have some sense of what policymakers’ regularities are going to be.

Why should we have any better idea of their “regularities,” as you say, in this brave new world than we had in the old?

For a couple of reasons. No. 1 is that in a war against inflation, the central bank to operate in a somewhat stealth fashion—because fighting inflation is a very anti-democratic thing to do.

Inducing a recession usually isn’t a big vote-getter?

Nor is opportunistically embracing them when they happen. Democracy is founded on the notion of one person, one vote and ergo must be inflation-prone. There is nothing wrong with that. As Churchill said, it’s the best of the worst forms of government. The thing is, capitalism is inherently prone toward the opposite because of its cumulative voting system of one dollar, one vote. It’s that inherent tension that I write about all the time. Fighting inflation involves having slack in men or machines, or as Marx said a long time ago, a reserve army of the unemployed. But it’s very difficult for a central bank to say , “Your brother-in-law is unemployed because we have to fight a war against inflation.”

Better you should think he is a lazy lout.

Exactly, because if they told you the truth, you’d have to contemplate letting him sleep in your rec room. You’d probably call your congressman and say, “I am not supportive of this policy.” Whereas, once the war on inflation is won, there’s no need for stealth, because you don’t want a perpetual state of slack in the economy to bear down on inflation. Conceptually, you want the economy to oscillate around full employment. So democratic accountability is easier to do, to my thinking, once you’ve won the war against inflation. That’s why the Fed could be more up-front. The second reason that they need to be more—and they are becoming more—transparent is that with rates this low, almost any cyclical movements in interest rates become movements in real interest rates. So the Fed needs to manage expectations of where it is moving real interest rates, to avoid miscommunication with the marketplace. It was different during the war on inflation. We all knew there was someplace lower they wanted to go on inflation. Therefore we had a beacon, however clouded it might have seemed.

At least it illuminated the direction inflation was headed.

Right, they wanted lower inflation in the fullness of time. But now, there is no place lower that they want it to go—but there is not a place higher they want it to go, either. Inflation risk is two-sided, which means that there is more need to manage policy expectations transparently, not less

Okay. But suppose they get everybody used to candor—then have to go back to inflation-fighting?

Well, they are going into inflation-fighting mode now, but only on a cyclical basis. Maybe it’s because of my PIMCO frame of reference, but I really want to stress the difference between cyclical and secular. Winning the war against inflation doesn’t mean that they won’t have to occasionally lean against the cyclical winds of inflation—just like they have to lean against the cyclical winds of dis-inflation. In a cyclical context, they have to lean against the wind in both directions. It is a very different paradigm than when you are fighting a secular war against inflation. For one thing, in a cyclical context, they have to have the cover, if you will, of inflation data. I don’t think they can be pre-emptive—nor should they be. Even if they wanted to be, it would be very difficult politically. By contrast, it is actually quite easy for the Fed to be reactive when faced with a cyclical uptick in inflation. Even Harry the dentist understands, “Yup, they are responding to evident increases in inflation that I see in my daily life.”

Yet the Fed is being criticized now for getting behind the inflation curve.

There will always be people on Wall Street and in academia saying that the Fed is a dollar late or a day short.

Your position is that the Fed has to be more careful not to throw us back onto the road to “unwelcome disinflation?” than it does of a little inflatio 

Exactly. That is why in my speech I talked about the “firebreak” idea that Greenspan introduced a year ago. It is every bit as appropriate a construct now as it was a year ago when we were all worried about deflation instead of inflation. Now that the war against secular inflation has been won, we need to have a firebreak or insurance policy in the inflation rate so that if the economy gets hit with a shock, we can take a recession— without going into the deflationary soup. By definition, you need to let inflation rise during the up-cycle because if it doesn’t—and you get hit with a shock that produces the down part of the cycle—you are in a heap of trouble.

And those shocks inevitably come, don’t they?

Sure, that was the essence of the Fed’s opportunistic disinflation policy. The irony is that after Volcker induced that first recession to bring inflation down, the Fed said, “We don’t have to induce any more. They will just happen, because stuff happens. When it does, inflation drops and we will just lock in those disinflationary dividends with pre-emptive tightening.” So the whole battle plan for the long war against inflation was predicated on the notion that stuff happens. It’s a highly realistic paradigm because the business cycle—and stuff happening—are a consequence of human nature. So unless human nature has been repealed, accidental recessions are on the horizon. You can’t forecast when they’ll hit, but my argument is that you want some room in the inflation rate so that when a non-opportunistic recession hits, you aren’t knocked into the deflationary abyss.

Because stuff also happens in wars against deflation.

Or in new eras of price stability. So if the Fed really believes that stuff happens, it would seem to be incumbent on the central bank to take out an insurance policy against stuff happening.

And you also say they should tell everybody about that insurance policy?

Exactly. What we really need here is a definition of price stability, or what some call an inflation target.

Targets are against Greenspan’s religion.

Targets are against Greenspan’s religion. But not necessarily against the Fed’s. I like the distinction that Fed Governor Ben Bernanke has been making between a “target” and a “definition.” A target implies a responsibility to hit it over some timeframe—which is why I was always against an inflation target during the war against inflation. That target would always have been below the actual inflation rate and the presumption would have been that the Fed should pursue it with dispatch and ignore the full-employment part of its dual mandate. Conversely, in April of last year, I came out in favor of the Fed adopting a definition of price stability because we know there is no place lower that the Fed wants inflation to go—but we need to know what the hell it is that they do want.

You are saying that we need to know how much higher would be too much of a good thing?

That’s right. Inflation risk is no longer one-sided, like it was in the 1980s and 1990s, when it was enough to know policy direction. Now it could be too low or too high. So you actually do need to know the definition of Goldilocks. We need a lot of thoughtful discussion about where that zone is and how much buffer is needed.

What’s your definition?

I am of the school of thought that says if the zone is 1-to-2% inflation in a world without shock risk or tail risk (on some core basis with appropriate smoothing and all of that), then you need to move that zone up to put in a buffer. In other words, if I actually thought the definition of price stability were 1-to-2%. I wouldn’t advocate a 1-to-2% target, I would take it up 50 basis points, maybe 100 basis points as a buffer against the stuff-happening scenario.

Would 1 percentage point be enough? I am thinking about what sometimes happens to rates when a fat tail hits.

There are times that policy makers need to get hugely negative real rates to jumpstart the economy. Which are very difficult to get when inflation is at a very low level. I don’t know what the correct number is. In my speech, I suggested it might be 3, 4, 5%. But until you have a definition of price stability, it is very difficult to have a useful dialogue about how much buffer zone you need. If you call that zone one standard deviation, what if you get a two-standard deviation event? The quality of policy-making and even more importantly, perhaps, how well that policy is communicated to the public and to the markets would be improved if we had a definition. And I forecast with a high degree of certainty that we will get one in the next five years—because Mr. Greenspan will be riding off into the sunset in the not too distant future. The simple truth is that his religious abhorrence of a quantitative definition is not a universal doctrine.

 He just doesn’t want to be pinned down.

Absolutely. He is living in a maestro-digm and he is the maestro. I understand that. He is human. But the Fed is an institution. Policy needs to be institutionalized, not going up and down in the elevator every day. I mean no disrespect to the Chairman. I am simply saying that the Fed as an institution is greater than any individual sitting in the chairman’s seat.

Better watch out. Lightning bolts may be heading in your direction!

Is that sacreligious?

Only in some circles.

There is a difference between proper respect and idolatry. We need to think these days about what the Fed is going to be like post-Greenspan. His term as governor is up in January ’06. And even though the President just re-appointed him Chairman, he can’t serve—except as a lame duck—beyond January ’06. The President does have the latitude to simply not nominate someone else, and whoever is chairman can stay until his successor is nominated and confirmed by the Senate. But I feel strongly that Greenspan would not do that. He just ain’t got a lame duck personality.

That pretty well sums it up.

Why would he want to? Actually I think that Greenspan is likely to do something very civic-minded—and consistent with comments his predecessor has made about the chairmanship of the Fed. Paul Volcker has said that in a logical world the Fed chairmanship should become available within a year or so of the national elections every four years, so that the President could make his own choice. Right now, it is just by accident that the chairman’s term ends in the summer of election years. And no logical person would say that the Fed chair’s appointment should precede the national elections every four years by three to four months. It undeniably would be nice to get it onto a cycle that makes sense in our political framework. So there would be a rationale for Greenspan to step down approximately a year after the election—even if it happens that the current President is re-elected.

Since when does what makes sense happen in Washington?

 Well, Volcker has also opined, as I said, that this sort of transition would be appropriate. After all, it is the second-most powerful job in America and we are living in a democracy. The guy sitting in the Oval office ought not to be held hostage to the fortunes of a silly calendar.

Especially since he’s the only one of the two who is elected.

Yup, exactly.

Let’s get back to how high cyclical inflation can safely go if we’ve really entered a new era (scary as that phrase is) of price stability?

Maybe I can reverse engineer myself into an answer. To me, price stability, or what the Fed should pursue, is an inflation rate that—to borrow a Greenspan phrase—is low enough that inflation doesn’t enter into long-term decision making as a critical variable. That’s what Greenspan always said during the war on inflation. I would amend that definition by adding that inflation should also be sufficiently high that you have a buffer against unwelcome disinflation in the event of a negative shock to aggregate demand.

That sounds textbook-ready.

It does, doesn’t it? At price stability, the Fed needs a buffer of inflation to give it flexibility. How much, what that number is, is the question that has to be asked. Many honest people could come up with different answers. But what frustrates me is that there still isn’t a consensus that it is even the right question to ask. It is amazing. Fed policy is the only area in the world where there is a massive reluctance to lay out the sort of quantitative parameters that we accept everywhere else in our life. On the freeway, the signs say 65. You are going to drive 73, but the sign says 65. When you fill out your taxes on April 15, the form doesn’t say send in the amount that you feel appropriate, given how good the economy has been to you and the public services you receive, in the context of your ability to pay. I mean, I don’t remember that section on the form.

I wish it were.

It would cause you to do some serious moral thinking, wouldn’t it? My point is, we put a number on all sorts of things. On how many beers you can have and still drive your car, because we have defined alcohol limits. We have all sorts of rules in our society and I support them. I don’t want people driving drunk. I don’t want them driving recklessly and I do want people to pay their taxes.

But you’re talking about regulating human behavior. There’s a school of thought that says markets work best when left to the invisible hand. Or at least, to regulate themselves. (Though what is a market but an amalgam of human decisions?)

Oh, I understand. But the fact that we live in a fiat currency world, with no backing for our currency except the good name, good faith, and good credit of we the people tells me that money is, at the end of the day, a political decision. I mean, lo and behold, this free market concept is founded on a fiat currency. Call me madcap, but I think that we in the market have to have a framework that accepts the notion that we aren’t on the gold standard any more. That money is as money does as Uncle Sam says, to paraphrase Forrest Gump. Sometimes it is smart and sometimes it ain’t. But there is no anchor for our commerce except a fiat currency. And I don’t have a problem with that. But the last time I checked, the market doesn’t freely determine the short-term interest rate.


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