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Economic and Market Commentary

Greenspan’s Best Friend​​

"Contrary to the assertions of some Fed mavens, this was a meaningful change in Fed policy..."

One of the oldest jokes in the world is the definition of a dilemma. What do you do when your mother-in-law drives over a cliff in your new Mercedes: laugh or cry? For me, the joke is an oxymoron, or worse a bad joke, because I adore my son’s maternal grandmother, and I drive a five-year old VW bug, not a new Mercedes. But the joke still inevitably elicits a chuckle from those who haven’t heard it, with some wiseacre in the audience always bellowing: Get insurance on your Mercedes!

Which, of course, is precisely what the Fed has been doing over the last year. With dollar-denominated goods and services prices disinflating at the bottom of the Fed’s implicit target zone of 1-2% (for the core PCE deflator), the Fed has run super accommodative policy, more accommodative than could be justified on the basis of the Fed’s base case outlook for the economy. This stance is an insurance policy against the risk of deflation:   a low probability event, but one with very high consequences. And the cost of that insurance has been a rush in dollar-denominated asset prices, notably the riskiest of such assets, to the edge of the irrationally exuberant cliff.

Mr. Greenspan’s dilemma has been whether to smile and ease to lift goods and services inflation, or to frown and tighten to arrest bubble proclivities in risk asset prices.

The figure is a line graph that charts the U.S. dollar index, the yield on 10-year constant maturity U.S. Treasuries (CMT), and the fed funds rate, from January 1987 to December 1987. The graph marks two key events with vertically-dashed lines: the Louvre Accord in February and Black Monday in October. After the Louvre Accord, the U.S. dollar index, scaled on the right-hand side, trends downward to about 0.80 by year-end, down from about 0.95 at the time of the agreement in February. Its decline steepens after Black Monday, when index is around 0.92%. Over the same time period, the 10-year CMT yield ends the year at about 8.8%, up from 7.2% at the time of the accord, but down from 10% on Black Monday. The chart also shows the fed funds target, which is about 6.75% by year-end, up from 6% at the time of the accord. 

Up until last week’s FOMC meeting, Mr. Greenspan had faced this dilemma by smiling through his clenched teeth, while promising to remain accommodative for a “considerable period.” At last week’s meeting, Mr. Greenspan and his colleagues decided to continue smiling.   But they unclenched their teeth, dropping the “considerable period” promise while introducing a new promise to be “ patient in removing its policy accommodation.”

More Than Semantics!

Contrary to the assertions of some Fed mavens, this was a meaningful change in Fed policy, even if it does not – as I believe – materially change the time of eventual Fed tightening. Definitionally, the path to tightening always included a ditching of the “considerable period” phrase. And, as I’ve thought and advocated 1, sooner would be better than later, at a time when unfolding economic circumstances still suggested that the FOMC would, in fact, remain on hold for – you got it! – a considerable period. A wise bartender stops advertising the availability of free food during happy hour well before happy hour is set to close. Last week was just such a propitious time.

When the Fed introduced the “considerable period” phrase last August 12, the FOMC had intended for that promise to be linked to the FOMC’s assessment of the risk of “unwelcome disinflation” – to wit, when that risk was no longer predominant, the “considerable period” would draw to an end. Regrettably, however, the FOMC hadn’t married its intent with its rhetoric, leading the markets to believe that the its pre-commitment to remaining “accommodative” was somehow linked to the calendar, rather than unfolding economic circumstances.

Indeed, as Fed Governor Bernanke and FOMC Secretary Vincent Reinhart explicitly acknowledged at the American Economic Association’s annual meetings on January 3, the conditional nature of the Fed’s precommitment to remain accommodative for a “considerable period” was only implicit, via a same-paragraph “association” between the precommitment and the reason for making it: “unwelcome disinflation” risk. This was a mistake, Messrs. Bernanke and Reinhart explicitly conceded, noting that the FOMC had fixed its mistake at its December 9th meeting:

“The conditional nature of the commitment was sharpened in the Committee’s December statement, which explicitly linked continuing policy accommodation to the low level of inflation and the slack in resource use.”

As noted in the December 2003 Fed Focus , I wholeheartedly endorsed this “sharpening” of the conditional nature of the FOMC’s pre-commitment to remaining “accommodative,” even as I lamented that the Committee had still retained the “considerable period” phrase. In turn, I forecast that:   

“…the FOMC will want to lose the ‘considerable period’ phrase at the earliest convenient time, not as a signal that tightening is imminent, but rather because the phrase will always be tainted with the connotation of calendar time.”

I further argued that:

 "...expect the whole Fed debate to soon shift from handicapping the time of the first tightening to arguing about what constitutes ‘accommodative.’ Can the Fed honor its commitment to remain ‘accommodative’ even as it hikes rates? Is the hiking of rates an act of non-accommodation, or is the level of the rate after the hike the proper measure of accommodation?

I believe hiking is tightening – non-accommodation! -- regardless of the post-hike level of the Fed funds rate. But many, if not most, FOMC members disagree, operating on the Bill Clinton doctrine that hiking ain’t tightening unless you are inhaling a tight level for the Fed funds rate.

So, get ready for the next great slicing of the semantic salami. I’ve got my Williams-Sonoma professional-quality machine ready. But first, when might be the ‘earliest convenient time’ to get rid of a ‘considerable’ period?

My gut says the two-day January 28-29th FOMC meeting, when the Committee officially blesses the Fed’s Semi-Annual Monetary Policy Report to Congress. But I don’t feel religious about this. The phrase doesn’t really bother me that much anymore, now that the FOMC has clearly
articulated the nature of its pledge to remain ‘accommodative’: the exit will be reactive to both higher realized inflation and higher resource utilization.”

Now, truth be told , at the 11th hour before last week’s FOMC meeting, I thought the odds leaned toward the FOMC retaining the “considerable period” rhetoric for at least one more meeting, despite the self-evident need to remove it. Why? I expected the FOMC to provide a re-enforcing rhetorical back-drop for what I believe should – and will – be America’s position at this week’s G-7 meeting in Boca Raton:  

The dollar is America’s currency but a falling dollar is not America’s problem; instead, rising non-dollar currencies that mirror a falling dollar are a foreign growth-stunting problem, and the problem that other G-7 nations should address with reflationary monetary policies. To wit, rather than tighter U.S. monetary policy, what the world needs is easier non-U.S. monetary policy. Put differently, what the world needs is for all G-7 currencies to fall relative to a basket of globally-traded goods and services, rather than just for the dollar to fall. 

The FOMC’s “considerable period” rhetoric had a positive side effect (what economists call an externality!) in underscoring America’s perspective that the world needs G-7 reflation, not just G-1 reflation. Thus, I thought the FOMC would pack Treasury Secretary Snow’s diplomatic holster 2 with “considerable period” lip powder one more time – for the good times, as Kris Kristofferson wrote long ago. But the FOMC didn’t, and in and of itself, that is more than cool by me.

Don’t Ever Do Another Louvre
Or at least I think it is! I say “think” because even though I disagreed sharply with the FOMC’s initial use of the phrase “considerable period” without a proper framework of conditionality, and also hated having to answer how long a “considerable period” might be, I was happy that the phrase precluded the need to contemplate any Fed disfavor, or even more importantly, market presumption of Fed disfavor, about the falling dollar.

Now, regrettably, I have to grapple with the possibility that this coming weekend’s G-7 meeting in Boca Raton will fail to extend the tacitly-coordinated reflationary process commenced at the last meeting on September 20 in Dubai. Recall, at the time, policy makers declared: 

“We reaffirm that exchange rates should reflect economic fundamentals. We continue to monitor exchange markets closely and cooperate as appropriate. In this context, we emphasize that more flexibility in exchange rates is desirable for major countries or economic areas to promote smooth and widespread adjustments in the international financial system, based on market mechanisms.”

At the time, the FOMC’s “considerable period” promise was freshly new and a powerful backstop to America’s commitment to a soft dollar policy (even if dressed up in Secretary Snow’s re-definition of a strong dollar as one that is physically hard to counterfeit). There could be no doubt in Dubai that if the dollar fell too much or too sloppily, the burden of responding to it did not rest in Washington, but rather in the capitals of the other G-7 members, notably Tokyo and Berlin.  

In a world of excess supply capacity and the risk of “unwelcome disinflation,” a falling dollar would not be a signal for monetary tightening in America, but rather monetary easing in other G-7 countries with appreciating currencies (or currencies that would be appreciating, if allowed to do so by foreign monetary authorities).

 Many mavens commented that the Dubai Accord was similar to the Plaza Accord of September 22, 1985, when America declared the dollar to be overvalued, and initiated a G-7 process to foster its orderly decline. There were certainly elements of Plaza in Dubai, but in my mind, Dubai was never Plaza 2, because at Plaza, policy makers had committed themselves to particular currency goals (implicit target zones), and they didn’t in Dubai. At least I don’t think they did. For those too young to remember, the power of Plaza was in paragraph 18 of the press release:

 “The Ministers and Governors agreed that exchange rates should play a role in adjusting external imbalances. In order to do this, exchange rates should better reflect fundamental economic conditions than has been the case. They believe that agreed policy actions must be implemented and reinforced to improve the fundamentals further, and that in view of the present and prospective changes in fundamentals, some further orderly appreciation of the main non-dollar currencies against the dollar is desirable. They stand ready to cooperate more closely to encourage this when to do so would be helpful.”

The key sentence from Plaza was, of course, that the G-7 had wanted a “further orderly appreciation of the main non-dollar currencies against the dollar.” And they committed themselves to policies supportive of the goal, including monetary policies (as evidenced by first-mover tightening from Japan shortly thereafter). In contrast, in Dubai, the G-7 did not explicitly seek “appreciation of the main non-dollar currencies” but rather sought that non-dollar currencies be allowed to move with more “flexibility.” This is not a difference without a distinction, but the exact opposite:   a defining difference!

 Everybody knows of course, that America wants non-dollar currencies to “flexibly” appreciate against the dollar. But America and its G-7 partners made no explicit or implicit promises about coordinating monetary policies, as had been the case at Plaza. Why is this so important?

If there have been no promises to coordinate monetary policy to facilitate appreciation in non-dollar currencies, there need not be any new set of promises somewhere down the road to stop such appreciation . The problem with the Plaza Accord of September 1985 was not the G-7 goal of stronger non-dollar currencies – which was warranted – but the implied commitment that monetary polices would eventually be re-coordinated to stop those currencies from appreciating or, alternatively, the dollar from depreciating. To wit, the nasty underbelly of Plaza was the presumption that if, in the fullness of time, the dollar’s depreciation became excessive, in the collective G-7 view, America would do something about it.

And indeed, time became full on February 22, 1987, when the G-7 met at the Louvre, and agreed that they should stop what they had started in September 1985:

“The Ministers and Governors agreed that the substantial exchange rate changes since the Plaza Agreement will increasingly contribute to reducing external imbalances and have now brought their currencies within ranges broadly consistent with underlying economic fundamentals, given the policy commitments summarized in this statement. Further substantial exchange rate shifts among their currencies could damage growth and adjustment prospects in their countries. In current circumstances, therefore, they agreed to cooperate closely to foster stability of exchange rates around current levels.That paragraph was, my friends, the proximate cause of the stock market crash eight months later, in October 1987. Yes, I do know that popular wisdom has it that the crash was the product of a disagreement between America and Germany that caused Treasury Secretary Baker to blow his stack at Germany for tightening monetary policy.

In a narrow sense, that is correct. But in a more important sense, Mr. Baker’s stack was stacked at the Louvre, when policy makers agreed to declare that enough was enough on desired appreciation in non-dollar currencies and that policies would be coordinated to ensure that enough was enough. The Louvre Pact was tested shortly later, on April 29, 1987, when in the face of yen strength against the dollar, the Bank of Japan eased and the Fed tightened on the same day.

It was very exciting the day it happened, as I recall, as the coordinated move highlighted the power of global monetary policy coordination. It was also a very dangerous precedent, however, as that episode created the impression that America would repeatedly tighten monetary policy, if the dollar were to weaken – to wit, that the Fed had made a pact with the devil at the Louvre. And, indeed, the Fed had.

I recently re-read the transcripts 3   – not minutes, but complete transcripts, which are released with a five-year lag – of every FOMC meeting in 1987, and it is unambiguously clear that the FOMC felt that it had been driven into a cul de sac, with the gate closed. The foreign exchange markets were pounding the dollar, testing the Fed’s willingness to subordinate its domestic policy goals on the altar of defending the dollar. And this was happening in the face of recalcitrance on the part of America’s G-7 to ease fiscal and/or monetary policy in supporting fashion.

Paul Volcker was Chairman through August of 1987, to be replaced by Alan Greenspan. Mr. Volcker’s anguish, and indeed the entire FOMC’s angst, about how to get out of the cul de sac, is painfully on display in the transcripts. In particular, Mr. Volcker’s fatalism about the unwillingness of Europe (more narrowly, the Bundesbank) to play coordinated ball was both cutting and prescient.

The devil entered the cul de sac in September, when the Bundesbank, in the face of an appreciating Deutschmark, tightened policy, squarely in the face of the Louvre understanding that all countries with appreciating currencies should resist tightening, if not pursue easing, as Japan had done in April.

In response to the Bundesbank’s Louvre-be-damned tightening, the markets quickly concluded that the burden of responsibility for arresting further dollar weakness rested more-than-fully with America, and the U.S. bond market began to discount draconian Fed tightening. Mr. Baker said hell no, forcefully declaring the Bundesbank to be the skunk at the picnic, and proclaimed that America would not defend the dollar in the face of the putrid smell of Bundesbank tightening.

In response, the U.S. bond market discounted even more draconian Fed tightening; and the U.S. stock market soiled its pants big time, culminating in the Crash of October 19. The next day, the Louvre Accord became history:   the Fed eased and the dollar declined sharply for the next two months, as displayed on the graph on cover.  

The lesson of the Plaza-Louvre saga is that you should not play at the Plaza if you don’t want to pay at the Louvre: America should never explicitly target the dollar with implicit commitments to changing Fed policy in response to the dollar’s movement, independent of the Fed’s domestic objectives. Conceptually, doing so would not be a problem if the dollar was too strong, but a commitment to act on upside implies a mirror commitment to act on downside. America, as custodian of the global reserve currency, should never make such a commitment.

Bottom Line
I don’t think America will blink at this weekend’s Boca summit. I worry a bit more about it now, however, than I did before the FOMC ditched its “considerable period” promise. I hope that I don’t come to miss those words, even as I hated them. They did serve the purpose of assuring that America had no intention of sacrificing the goals of domestic job creation and domestic price stability on the altar of global policy coordination. This was particularly important given that the global policy coordination church has ghosts of the Bundesbank lingering in the nave, wearing ECB hats.

For the moment, I don’t think we have to worry too much about the risk of America blinking its reflationary dollar policy, and a Louvre Accord repeat. Mr. Greenspan assumed his current job just before the Louvre Accord blew up, blowing up the stock market, and I don’t think he wants to revisit that devilish cul de sac. Both Mr. Greenspan and Mr. Snow are currently pegging the mojo meter when it comes to the goal of domestic job creation. And this is the way it should be.  

At the margin, however, I do have increased worries about Mr. Greenspan’s continued willingness to docilely accommodate the president’s reflationary fiscal and exchange rate policies.   Central bankers are taught from birth to rant at fiscal policy authorities to suck it up, and consider themselves the ultimate viceroys of foreign exchange policy, even if finance ministers are notionally in charge.  

Greenspan has less than two years to go now (he can’t be legally reappointed to another 14-year term as governor when his current term ends in January 2006, even though he can be re-appointed to another 4-year term as chairman this summer), and is playing for the history books. I don’t believe he will want to leave his successor with a son-of-Louvre mess like he inherited.    

At the same time, I do think that Mr. Greenspan is starting to worry about risk assets inching too close to the edge of the irrationally-exuberant cliff. Indeed, my hunch is that this worry was the dominant reason he led the FOMC to ditch the “considerable period” rhetoric last week, when G-7 exigencies argued against it. And in a narrow sense, I understand his (presumed) logic: every day I observe moral hazard in play in the market place, as investors in risk assets buy them at risk premiums that make no sense, except in belief that Uncle Alan wouldn’t dare hurt them by tightening.

Thus, Mr. Greenspan now faces a far greater dilemma than the chap watching his mother-in-law drive off a cliff in his new Mercedes. Mr. Greenspan’s best friend – his dog, Irrationally Exuberant Stocks – is in the car.

The investment implications of it all? Take out insurance: cut risks and be willing to marginally underperform benchmarks (via yield give up), so as to avoid colossally underperforming them. Or, as I said in November 4, my investment motto for 2004 is: Pleasure should be about avoiding pain. 

Paul McCulley
Managing Director
Febrrary 4, 2004

1Through Holes In The Floor Of Heaven,” Fed Focus, December 2003.
2 Our Currency, But Your Problem,” Fed Focus, October 2003.
3 Federal Reserve Bulletin, 1987, issue June, pages 425-430.
4 When Pleasure is About Avoiding Pain,” Fed Focus, November 2003.


Past performance is no guarantee of future results. This graphs portrayed are not indicative of the past or future performance of any PIMCO product. This article contains the current opinions of the manager and does not represent a recommendation of any particular security, strategy or investment product. Such opinions are subject to change without notice. This article is distributed for educational purposes and should not be considered investment advice.

Each sector of the bond market entails risk. Municipals may realize gains and may incur a tax liability from time to time. The guarantee on Treasuries and Government Bonds is to the timely repayment of principal and interest, shares of a portfolio are not guaranteed. Mortgage-backed securities and Corporate Bonds may be sensitive to interest rates. When interest rates rise, the value of fixed income securities generally declines and there is no assurance that private guarantors or insurers will meet their obligations. An investment in high-yield securities generally involves greater risk to principal than an investment in higher-rated bonds. Investing in non-U.S. securities may entail risk due to non-U.S. economic and political developments, which may be enhanced when investing in emerging markets.

No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission.  Pacific Investment Management Company LLC ©2004 PIMCO.

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