Get documents about "McCulley March 25
Shared by: zerohedge
-
Stats
- views:
- 4237
- posted:
- 3/26/2010
- language:
- English
- pages:
- 12
Document Sample
Global
Paul
McCulley Central Bank Focus
April 2010
Comments Before the Money Marketeers Club
Reflections and Ruminations
New York City
March 25, 2010
Thank you for that most kind introduction, time, my axe may be revealed to be dull or
Nancy. It is indeed an honor to be address- perhaps, not even an axe at all, but rather a
ing this august group for the fifth time, hammer against my head.
especially sharing time with friends going
back over 25 years. It’s great to see you! What is “Neutral?”
In my first address1 to you, on April 26, 2004,
While I’ve given hundreds, if not thou- the Federal Reserve was on the cusp of
sands, of speeches over the years, the ending its “considerable period” of a 1%
only ones I ever write are to the Money Fed funds rate, set to embark on a journey
Marketeers Club. Not that I deliver them back toward “neutral” monetary policy.
as I write them, which is probably congen- I had no quarrel with the direction of where
itally impossible for me to do. But I write the Fed was about to go.
them both out of respect for this audience,
as well as to force me to think intensely as The “considerable period” pre-commit-
to what I’m saying in the context of what ment to 1% Fed funds had worked its
I’ve said before. magic, inducing animal-spirited risk-
taking on both Wall Street and Main
Yes, here at the Money Marketeers, I Street, and it was time, as I put it, for the
explicitly own my priors, even if that can Fed to end “happy hour prices” for liquid-
be extremely painful at times. I always ity: Wall Street patrons had more than a
have an axe to grind and in the fullness of comfortable buzz.
Global Central Bank Focus
My axe to grind wasn’t with the Fed’s the Taylor Rule drop out, and the neutral
looming tightening trajectory, but rather nominal Fed funds rate is simply the 2%
what would be the destination, commonly neutral real Fed funds rate assumption
known as “neutral.” Consensus market plus the at-target inflation rate, which
opinion was centered on 4%, while I was Taylor assumed – and the Fed preached
centered on 2½%. How so? both then and now – to also be 2%.
The workhorse model for contemplat- Thus, in an equilibrium Taylor world, the
ing the destination was (and is to this neutral nominal Fed funds rate is 4%, which
day!) the Taylor Rule, primarily because is why, in my view, the consensus view in
Professor Taylor made one huge, simplify- April 2004 held that the looming tightening
ing assumption, that the neutral real Fed cycle would take the Fed funds rate at least
funds rate is a constant 2%. that high (and presumably, higher if and
when inflation rose above target and/or the
With that assumption, plus assumptions unemployment rate overshot the NAIRU
for the Fed’s implicit inflation target and to the downside, implying the need for
the Fed’s estimate of the full-employ- “restrictive” monetary policy). John Taylor’s
ment GDP potential (alternatively, the insights were and are very powerful.
NAIRU), it is easy to calculate where the
Fed putatively should, according to Taylor, And, indeed, his Rule is elegant. But it is
peg the nominal Fed funds rate. Indeed, also hostage to his assumption that the
Bloomberg now has a plug-and-play neutral real Fed funds rate is a constant
version of the Taylor Rule, where anybody 2%. I didn’t buy it in 2004 and don’t buy
can pretend to be a FOMC member. it today. In fact, I had voiced this view
prior to that April 2004 first evening with
And most conveniently, if you assume that you, notably in my August 2003 monthly 2
inflation is at target and unemployment (ironically just as the Fed evoked the “con-
is at the NAIRU, all the “active” terms in siderable period” regime). My thesis was
April 2010 Page 2
simple: The neutral real, after-tax Fed purchasing power, but no more: No risk,
funds rate should be zero! no real return!
Money and Private Capital In contrast, private capital, specifically
are Different long-dated bonds, carries both default risk
My rationale? Overnight money is fun- and price risk. Thus, I argued that private
damentally different than private capital. real long-term rates should be much more
Money carries zero default risk and zero positive, approximating the economy’s
price risk: A buck is a buck is a buck. long-term potential real growth rate, which
To be sure, holding money does involve I estimated back then to be about 3%–3½%.
paying two taxes: (1) the tax on nominal Subtracting a long-term swap rate of about
interest income and (2) the purchasing 50 basis points, as it was in spring 2004,
power loss of at-target inflation. I conjectured that the “equilibrium” real
10-year Treasury yield should be 2½%–3%.
Accordingly, I proposed that the neutral Adding back the Fed’s 2% inflation target,
real Fed funds rate should be the econ- that implied a fair-value nominal 10-year
omy-wide marginal tax rate, which I Treasury yield of 4½%–5%.
assumed to be 20%–25%, times the Fed’s
2% inflation target – about 50 basis points, There was, of course, one problem with my
in contrast to Taylor’s assumption of two market-segmentation view of the difference
percentage points. Thus, my estimate of between money and private capital, which
the neutral nominal Fed funds rate was I fully recognized: it structurally implied
2½%, in contrast to the 4% estimate falling a very steep yield curve – 2%–2½% from
out of the Taylor Rule. Fed funds to 4½%–5% for 10-year Treasury
yields. Such a steep curve would, I recog-
Bottom line: The Fed funds rate, the nized, offer a structural real reward for
return on money, should be suffi- levering into the duration-mismatch
ciently high to maintain money’s real carry trade.
Page 3
Global Central Bank Focus
Thus, on that April 2004 evening with you, system, founded on the carry trade of
I said: funding long-dated assets with short-
dated liabilities, fat-tailed liquidity risk
“If the Fed were to enforce my view of the be damned.
‘neutral’ real short rate, the Fed and other
financial regulators would need to enforce Thus, financial conditions, defined not
quantitative rules on growth in levered just as the price of credit but its availabil-
players’ balance sheets, so as to prevent ity and terms, were getting progressively
unbridled growth in credit creation via easier as the Fed was “normalizing” the
the carry trade.” Fed funds rate up. Financial intermediar-
ies, both conventional banks and shadow
And, to my shame, I actually thought that banks, were doing exactly what I feared
would happen, with proposed regulatory they would do, in the absence of regula-
limits on growth in the GSEs at the time as tory constraint on growth in leverage.
my putative harbinger.
The carry trade of maturity transforma-
How wrong could I be! The Fed did not tion – funding long-dated assets with
stop tightening near 2½% but just over short-dated money – is the mother’s milk
twice that number, at 5¼%. And a key of banking from time immemorial. And
reason is that the Fed, and even more the unfettered invisible hand of the finan-
important, other financial regulators – and cial capitalism market could not resist
here I include the Rating Agencies, who reaching for the sky, on the proposition
are literally hardwired into the regulatory that the sky was no limit for asset price
architecture – did absolutely nothing to appreciation, notably for property, both
quantitatively restrain growth in lever- residential and commercial. Systemic
age. In fact, they did exactly the opposite, degradation of underwriting standards
acquiescing to, if not cheerleading, explo- was the gin in the bath tub.
sive growth in the shadow banking
April 2010 Page 4
All of this had, of course, become abun- To wit, the FOMC was concerned that
dantly clear before I spoke before this financial conditions were becoming more
group the second time, on February 27, accommodative, even as the Fed funds rate
2006. And chastened, I had already pub- was becoming less accommodative. And
licly confessed my forecasting sins, since the FOMC was manifestly unwill-
starting with my January 2005 essay 3, ing to use regulatory tools (now known as
“Shades of Irrational Exuberance,” macro-prudential tools) to deal with the
ironically the month before Chairman putative excessive risk-taking, it was bla-
Greenspan famously declared that it was a tantly obvious that the Fed funds rate was
conundrum that long rates were falling as going to go up very meaningfully further.
the Fed was hiking the Fed funds rate.
And then in my September 2005 essay,5
The motivation for the essay was, in fact, “Pyrrhic Victory,” I confessed my forecasting
minutes 4 of the December 14, 2004 FOMC sins yet again, after Chairman Greenspan’s
meeting, when the Fed funds rate was August 2005 speech in Jackson Hole, when
hiked to 2 ¼%. Those minutes explicitly he spoke elegantly about the dangers inher-
declared Fed concerns about: ent in excessively-thin risk premiums
(excessively-high risk asset prices).
“...signs of potentially excessive risk-
taking in financial markets evidenced Mr. Greenspan left little doubt that unless
by quite narrow credit spreads, a asset prices corrected of their own accord,
pickup in initial public offerings, an he was, as I put it, going to “take off his
upturn in mergers and acquisition belt of nasty tightening, which is likely to
activity, and anecdotal reports that invert the yield curve.” And so he did.
speculative demands were becoming
apparent in the market for single- In Comes Chairman Bernanke
family homes and condominiums.” When I spoke before this Club on February 27,
2006, my April 2004 forecasting sins fully
Page 5
Global Central Bank Focus
confessed and just after Chairman dubbed the OLIR – the Optimal Long-term
Bernanke had taken his seat, I had a new axe Inflation Rate. I thought that was a colos-
to grind: the merits of inflation-targeting, sally smart idea.
long a favorite chestnut of Mr. Bernanke.
But I did have one quarrel, as is my nature:
I applauded the new chairman, having I thought the prevailing implicit definition
become an inflation target advocate of the OLIR, known as the “comfort zone”
myself in April 2003, when I (along with of 1½%–2% for the core PCE deflator, was
Bill Dudley, then Chief U.S. Economist both too low and too narrow, declaring
of Goldman Sachs and current NY that “gun to head, I’d suggest 1½%–3%.”
Fed President) wrote an essay 6 for the
Financial Times arguing that the FOMC My reason: I thought market participants’
should state that the very accommodative hubristic belief that the Fed should, could
policy of the time, designed to cut off the and would always achieve the 1½%–2%
fat tail of deflation risk, would remain in comfort zone was actually one of the “cul-
place until the Fed achieved a 2% or higher prits” in excessively-low risk premiums.
inflation target. A wider comfort zone for inflation, with
the Fed allowing more cyclical varia-
The FOMC didn’t follow that advice tion within it would, I believed, increase
directly, but as a practical matter, it market participants’ uncertainty and thus,
essentially did when initiating the exit foster somewhat wider risk premiums.
in June 2004. So I was actually in a pretty
warm and fuzzy mood when I spoke to To wit, a higher and wider comfort zone
you in February 2006. for inflation would make the financial
markets less bubble prone. And that, I
I reviewed Mr. Bernanke’s October 17, thought, would be a good thing, because
2003 speech,7 when he advocated that the it would reduce the odds of an eventual
FOMC calculate and announce what he debt-deflationary Minsky Moment.
April 2010 Page 6
But I was clearly running my analytical the FOMC having cut it 75 basis points
digger both belatedly and where there was in September and October. Might Fed
no FOMC dirt. Seventeen months later, in funds fall, I mused, all the way to 2½%,
August 2007, the Minsky Moment arrived. the level that I had mistakenly forecast
in May 2004 would be the peak of the
All About Minsky looming tightening cycle?
This was the backdrop for my November 15,
2007 visit8 with you, when I preached, My response:
literally preached, the importance of under-
standing Minsky’s Financial Instability “I honestly don’t know. What I do
Hypothesis in contemplating where we know, or at least think I know, is that
were and where we would likely go. the slower the Fed is in lowering the
Fed funds rate, the greater will be the
The Forward Minsky Journey of the cumulative decline in the Fed funds
preceding twenty years had come to an rate. Debt deflation is a nasty beast
ignominious end, I argued, and a Reverse and will not be tamed with a gentle
Minsky Journey was underway, in which monetary policy response.”
“Ponzi Debt Units are destroyed, Speculative
Debt Units are severely disciplined, and Which brings me to my last visit with you
Hedge Debt Units make a serious comeback.” on March 19, 2009.9 The Fed funds rate
And indeed, that Reverse Minsky Journey resided in a 0–25 basis point range, where
unfolded in 2008, in ways more nasty than it stands to this day. I simply hadn’t been
I ever envisioned, culminating in a global bold enough in forecasting how nasty the
financial and economic cardiac arrest debt deflation beast would be!
following Lehman’s fall in September.
And with the zero lower bound hit for
The Fed funds rate stood at 4½% on the Fed funds rate, credit easing and
that November 15, 2007 evening, with quantitative easing (QE) were underway.
Page 7
Global Central Bank Focus
I applauded the Fed, loudly, for what it Now and Looking Forward
was doing. The economy was suffering A year later, the evidence is in: Depression
10
from both the Paradox of Deleveraging 2.0 has indeed been avoided. No, I haven’t
and the Paradox of Thrift, and the only yet bought that second home. In fact, I
way to break those paradoxes was, I actually sold my only one, at a good level,
argued, to substitute the sovereign’s as I was no longer using it, preferring to
balance sheet for the deflating private live in a little rental house on the water
sector balance sheet. where I have my 32-foot fishing boat,
named the Moral Hazard, and my 18-foot
America was doing it, with three balance electric Duffy boat, named the Minsky
sheets in operation: the Fed’s, the Moment. Yes, I am sorta non-normal.
Treasury’s with TARP and the FDIC’s with
increased deposit guarantees and And so is the current configuration of Fed
the introduction of unsecured debt guar- policy, with the policy rate pinned against
antees. It was an “all in” strategy and zero in the context of a very bloated
that was precisely what was required, balance sheet and huge excess reserves in
I intoned. I advocated that most major the system. It’s non-normal because we
countries should join the Fed in aggressive are living in non-normal times and that
QE, effectively generating a Competitive is likely to be the case for an extended
QE game, in which all fiat currencies were period, to steal a phrase.
devalued against things, with gold being
a proxy for things. But in the fullness of time, there will come
a time when the Fed will want to nor-
I was generally upbeat, going so far malize policy to the new world we face,
as to suggest that I was contemplating a continuing Reverse Minsky Journey of
buying a second home, on the notion that private sector deleveraging and de-risk-
Depression 2.0 would be avoided. ing, but at a glacial pace, rather than the
panic pace of the last couple years.
April 2010 Page 8
Thus, I cringe when I hear men like an eventual neutral Fed funds rate of 2½%,
Kansas City Fed President Tom Hoenig just as I did way back in 2004 – a real rate
muse that the Fed will ultimately need to of 0.5% plus a 2% inflation rate.
get the Fed funds rate back up to a 3½%–
4½% zone. I deeply respect Mr. Hoenig, But I think it will be a long time before the
both as an economist and a man, but I Fed takes us there, as the “active terms”
just don’t see why the Taylor Rule of the in the Taylor Rule are still very active,
Forward Minsky Journey should apply to working in the same downward direction:
the Reverse Minsky Journey. Inflation is below target and headed lower
still, primarily because unemployment is
Simply put, the 2% real Fed funds rate several percentage points above the Fed’s
constant in the Taylor Rule should, in unchanged 5% estimate for NAIRU.11
my view, be considered toast. In a world
of deleveraging and hoarding of cash, And for 10-year Treasuries? Six years ago,
it makes absolutely no sense to reward I assumed potential real GDP growth to
holders of cash with an after-tax real rate be 3%–3½%. In a world facing a prolonged,
of return. even if a less nefarious Reverse Minsky
Journey, I think 2%–2½% is a more plau-
To be sure, I stand by my long-ago sible estimate, which should be the anchor
proposition that the holders of always- for private real 10-year yields, defined
trades-at-par cash should be compensated as the real swap rate. In turn, assuming
for both the explicit tax on interest income swap spreads hold near flat, as at present,
and the implicit tax of inflation. I also this implies a 4%–4½% fair value range
stand by my proposition that the FOMC’s for both nominal 10-year swaps and
comfort zone should be 1½%–3%, up Treasuries. But this will only be the case
from 1½%–2%. But I doubt seriously that when the market can credibly discount
the Fed will ever explicitly increase its that the Fed will have the economic justi-
implicit inflation target. Thus, I envision fication of an at-target (2%) inflation rate
Page 9
Global Central Bank Focus
and an at-NAIRU (5%) unemployment to Financial Conditions cannot be properly
lift the nominal Fed funds rate to its 2½% analyzed by simply creating a weighted
“neutral” nominal level. average of various asset prices and risk
premiums, but must include variables
Would such a yield curve, flatter than at that capture the evolution of leverage and
present, but still reasonably steep, beget the terms and availability of credit, not
speculative excess via leverage, as was simply its price.
the case in the mid-2000s? I don’t think
so, because policymakers have learned The quintet’s conclusion was:
that regulation of leverage is not an evil,
but a missing virtue that now becomes an “…several components of our FCI that
imperative. The shadow banking system have not been previously included –
will, I believe strongly, be a small shadow particularly quantity indicators related
of itself for a long, long time. Thus, while to the performance of the ‘shadow
I’m sure I will be wrong about many banking system’ such as ABS issuance
things in the years ahead, I have few fears and repo loans, as well as total finan-
that unbridled, unregulated leverage will cial market cap – have failed to improve
again be the dog that bites me. much if at all.”
Providing support for that proposition is A Financial Conditions Index with a
the newly devised Financial Conditions Minsky Innovation: what a beautiful
Index created by a quintet of eminent thing! And it has profound implications
academic and financial market econo- for how we think about the concept of
mists for last month’s U.S. Monetary Policy a neutral Fed funds rate, even if you
Forum, sponsored by the University of don’t buy my thesis that the after-tax
Chicago Booth School of Business.12 real return on cash should, in an “equi-
It’s a devilishly wonkish paper, but librium” world, be approximately zero.
its contribution is profoundly robust:
April 2010 Page 10
My 2003 Financial Times co-author Bill possibility that the equilibrium rate
Dudley was a formal discussant for the changes in response to technology
paper when it was presented, and spoke shocks or in response to changes in how
directly to this point: monetary policy is transmitted via the
financial system to the real economy.”
“I would note that financial conditions
indicators have implications for ‘Taylor Amen and amen, President Dudley.
Rule’ formulations for monetary policy. The Fed pegs the Fed funds rate, but
As you all know, Taylor-type rules where that peg should be is not just a
provide a short-hand metric for the matter of its influence on asset prices
appropriate stance of monetary policy. and risk premiums, but the architec-
In such rules, the fed funds rate is set at ture of the financial system. And if the
a level equal to the equilibrium real fed shadow banking system is going to be a
funds rate, plus the inflation objective, regulated shadow of its former un-regu-
plus the weighted deviation of output lated self, the neutral real Fed funds rate
from its potential and of the inflation is going to be a down-sized shadow of its
objective from actual or, if forward former self.
looking, expected inflation. Often, ana-
lysts and economists assume that the I’ve talked too long. Thank you, my
equilibrium real fed funds rate is equal friends, for inviting me here tonight. What
to 2%, its long-term historical value. a long strange trip it’s been since my first
Although, in principle, such rules allow time at this podium in May 2004, when
the equilibrium rate to be time varying, Wall Street was increasingly driving
it typically is assumed to be constant. Main Street, eventually to the cusp of
Depression 2.0. May the journey ahead
I have always been uncomfortable with be much less strange, even boring, with
this usage of a 2% equilibrium real Wall Street returning to its proper role
rate assumption because it ignores the of facilitator of Main Street’s rightful
Page 11
Facebook…
ambitions of rising standards of living, 1
Fed Focus: “Comments Before the Money Marketeers Club: Stay up to date on
A Brave New World” (May 2004), http://www.pimco.com/
more equitably distributed. PIMCO with Facebook.
LeftNav/Featured+Market+Commentary/FF/2004/ff_05_04.htm
2
Search “PIMCO.”
Fed Focus: “Needed: Central Bankers with Far Away Eyes”
(August 2003), http://www.pimco.com/LeftNav/Featured+
Market+Commentary/FF/2003/FF_08_2003.htm twitter…
May Wall Street re-learn the doctrine of 3
Fed Focus: “Shades of Irrational Exuberance” (January 2005), Stay in touch with
http://www.pimco.com/LeftNav/Featured+Market+Commentary/ PIMCO. Search
profit-motivated stewardship, and dis-learn FF/2005/FF_Jan_05.htm
“PIMCO.”
4
http://www.federalreserve.gov/fomc/minutes/20041214.htm
the false god of speculation-driven avarice. 5
Fed Focus: “Pyrrhic Victory” (September 2005), http://www.
pimco.com/LeftNav/Featured+Market+Commentary/FF/2005/
FF+September+2005.htm
6
“Greenspan must got for higher inflation,” Financial Times,
April 24, 2003.
Paul McCulley 7
http://www.federalreserve.gov/boarddocs/speeches/2003/20031017/
default.htm
Managing Director 8
Global Central Bank Focus: “Comments Before the Money
Marketeers Club: Minsky and Neutral: Forward and in Reverse”
mcculley@pimco.com (December 2007), http://www.pimco.com/LeftNav/Featured+
Market+Commentary/FF/2007/GCBF+Dec+2007.htm
9
Global Central Bank Focus: “Comments Before the Money
Marketeers Club: Playing Solitaire with a Deck of 51, with Number
52 on Offer” (April 2009), http://www.pimco.com/LeftNav/Featured+
Market+Commentary/FF/2009/Global+Central+Bank+Focus+
April+2009+Money+Marketeers+Solitaire+McCulley.htm
10
Global Central Bank Focus: “The Paradox of Deleverag-
ing Will Be Broken” (November 2008), http://www.pimco.
com/LeftNav/Featured+Market+Commentary/FF/2008/
Global+Central+Bank+Focus+11-08+McCulley+Paradox+of+
Deleveraging+Will+Be+Broken.htm
11
Some believe NAIRU will be somewhat higher going forward than
prior to the crisis of recent years, and I have some sympathy with
that proposition, perhaps a percentage point. But as experience has
painfully taught me, substituting my view for the Fed’s revealed
view is not a good starting point for forecasting the Fed!
12
J. Hatzius, P. Hooper, F. Mishkin, K. Schoenholtz and M. Watson,
“Financial Conditions Indexes: A Fresh Look after the Financial
Crisis” (February 2010), http://research.chicagobooth.edu/igm/
events/docs/2010usmpfreport.pdf
840 Newport Center Drive
Newport Beach, CA 92660
949.720.6000
Past performance is not a guarantee or a reliable indicator of future results. This article contains the current
opinions of the author but not necessarily those of the PIMCO Group. The author’s opinions are subject to change without
notice. This article is distributed for informational purposes only. Forecasts, estimates, and certain information contained
herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any
particular security, strategy or investment product. Information contained herein has been obtained from sources believed to
be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication,
without express written permission of Pacific Investment Management Company LLC. ©2010, PIMCO. BF095-031810
