Paul McCulley, Pimco's very own monetary maestro, has been flying around the globe lately, telling gatherings of central bankers to get with the new paradigm. And to get re-armed. In June, the Fed raised its target for the Federal Funds rate by one quarter of one percent. The war against secular inflation clearly has been won, Paul says, but this is no time for the monetary authorities to relax. -KMW
There's an ugly rumor going round that you recently gave a speech in Switzerland asking the Fed to lay more rules on the markets-What 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. 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. 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?
No. 1 is that in a war against inflation, the central bank has 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?
Democracy is founded on the notion of one person, one vote and ergo must be inflation-prone. The thing is, capitalism is inherently prone toward the opposite because of its cumulative voting system of one dollar, one vote. 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. The second reason that they need to be 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. It was different during the war on inflation. We all knew there was someplace lower they wanted to go on inflation.
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. Winning the war against inflation doesn't mean that they won't have to occasionally lean against the cyclical winds of inflation. In a cyclical context, they have to lean against the wind in both directions. It is a very different paradigm.
Your position is that the Fed has to be more careful not to throw us back onto the road to "unwelcome disinflation?"
Exactly. That is why in my speech I talked about the "firebreak" idea that Greenspan introduced a year ago. 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 that 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."
And you also say the Fed 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. I am of the school of thought that says if the zone is 1-to-2 percent 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 percent. I wouldn't advocate a 1-to-2 percent 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 long tails hits.
There are times that policy makers need to get hugely negative real rates to jumpstart the thing. Which are very difficult to get when inflation is at a very low level. In my speech, I suggested it might be 3, 4, 5 percent. 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? And I forecast with a high degree of certainty that we will get one in the next five years. 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. 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.
But, you want more. Not just a definition of inflation-
We need to have open discussion in the marketplace and at the Fed – and between them – about what constitutes the neutral real short-term interest rate. Everyone is averaging numbers from the 1970s, '80s and '90s on the notion that whatever was the average in the past will be the average in the future. But I say, if we are in a new paradigm of winning the peace of price stability and not fighting a war against inflation, we need to re-examine first principles and assumptions. Everyone is just assuming that it is 2-to-3 percent, as Professor Taylor told us years ago.
You're suggesting the Taylor Rule is wrong now?
I have a whole different theory about how you should arrive at what is the "neutral" short-term rate.
What is a neutral rate?
What rate is consistent with neutrality between holding money and holding a basket of goods? There are shades of the gold standard in that question, of course. But I am not now and never have been a gold bug! But it's worth remembering that under a gold standard, money does not buy more ounces of gold over time, but the same number of ounces. So my notion is that the modern equivalent of the gold standard would be a nominal rate of interest on money that would make the holder whole for the two taxes that our government imposes on money: the explicit tax on nominal interest and the implicit tax of inflation.
You are saying that the real short-term rate is neutral if the after-tax rate is zero?
Exactly. Assuming, of course, that the pre-tax real rate is positive, so that it generates enough nominal interest that the owner has to pay taxes on that nominal interest. The other thing is that the higher the inflation rate, the higher the "necessary" real rate. That way, money would retain its value in real terms. If someone wanted to generate a real return on his store of wealth, he'd have to take real risk -principal risk, duration risk, credit risk, equity risk, or any of a million other kinds of risk.
Linking risk to return? You are a mad cap!
I know. But in a low-inflation world, this implies a steep yield curve as investors demand compensation for assuming the real risk of losing principal in real time in the event of a shock. And if inflation then accelerated sharply, the real yield curve would bearishly flatten because the "neutral" short rate would rise – and it would rise more-than-arithmetically with that rising inflation. But that would produce the desired result, pulling inflation back down towards price stability, by slowing the economy.
But doesn't that imply that the yield curve would be pretty steep most of the time-and so encourage folks to pile on even more leverage through the infamous carry trade?
I don't think so, provided the Fed were willing to allow inflation to oscillate with the cycle. Nominal interest rates would move up and down with inflation – and impose the real risk of cyclical losses on speculators plying the carry trade.
But would that be enough to restrain those animal spirits? A lot of investors have evidently gotten very hooked on carry trade profits-
Maybe not. Who knows? But if not, the Fed could employ a very viable tool to dampen such excessive irrational exuberance. The Fed could impose variable overcollateralization requirements on repos, instead of the standard 102 percent that it currently requires of investors seeking to borrow liquidity from it indirectly, via its open market desk. The thing is that the Fed's traditional 102 percent overcollateralization requirement in the repo market means in practice that an investor can lever Treasuries 50-to-1 [by holding only the required 2 percent equity capital.]
That skimpy overcollateralization requirement wasn't intentionally designed as an open invitation to speculative excess, was it?
No, the repo market, of course, is the central bank's conduit for monetary policy actions that set the short-term policy rate. And the 102 percent rule is merely the Fed-approved standard for protection against default risk on the part of borrowers in the repo market. In fact, the 102 percent is written into every repo agreement we sign. So repo market participants, like Pimco, view the 102 percent rule as merely a prudent safeguard against the risk that a borrower can't make a margin call.
If I can take this conversation to a different plane for a minute, there are those on Wall Street who will insist you're nuts to be worrying about a new era of price stability, when inflation is already rearing its ugly head –
The fact is that we have always had problems with the data. As for the political issues, the real ones come back to the entitlement programs and the commitments that we have made to ourselves as a people. Like to provide – on a non-means-tested basis – a comfortable retirement with munificent healthcare. But whether we as a people can afford to honor our commitment to ourselves is the critical question. The answer I come up with is "no." Ultimately, we have got to move to means testing, which we could do in a variety of ways. For one, you could tax Social Security benefits more aggressively.
I can already hear the screaming and yelling. Thanks, Paul.
Kathryn M. Welling is the editor and publisher of welling@weeden, an independent research service of Weeden & Co., L.P. Greenwich, Conn. http://welling.weedenco.com