This week we take a look again at my good friend Peter Bernstein, the venerable editor of Economics and Portfolio Strategy. Peter is the dean of economic writers. (Actually, he is more like the Pope of economic writers, except of course, that he is Jewish.) The first and long time editor of the prestigious Journal of Portfolio Management (now serving as a consulting editor), Peter has been observing the investment world for almost 60 years, after serving as a captain in the Air Force in WW2. During his career, he has rubbed shoulders and influenced the movers and shakers in our world. He is the author of nine books in economics and finance plus countless articles in professional journals such as The Harvard Business Review and the Financial Analysts Journal, and in the popular press, including The New York Times, The Wall Street Journal, Worth Magazine, and Bloomberg publications.
His book, Against the Gods - the Remarkable Story of Risk is one of my top five, you gotta read it books. (www.Amazon.com) His latest book, Wedding of the Waters is a powerhouse of historical economic story-telling about the Erie Canal.
Several weeks ago in Outside the Box we looked at Paul McCulley's piece called "Phyrric Victory" and Bernstein offers his views on the subject by critiquing McCulley. Bernstein sees the expectations on inflation being much different than in the past and adverse surprises may be in our future. It is the risk we don't see that always causes the problems and that is why this article became this week's Outside the Box.
You can find out more about my friend Peter by going to http://www.peterlbernsteininc.com/. His newsletter is a must read for serious investors and institutions.
John Mauldin, Editor
Outside the Box
Where Should We Put The Greenspan Put?
Has Katrina caused so much turmoil and disruption that the outlook for monetary policy is a clean break with the recent past? We think not. Shifts may occur, but the same members of the Open Market Committee are still sitting around the same table. Alan Greenspan continues to preside; even though his time is running out, memory of him will linger on for a long time to come. There was a policy in motion before the hurricane hit.
Despite the disruption, we expect everything that happens in the near future to be influenced by what came before. The fundamental character of the Greenspan régime, its responses to crisis, and the market's responses to the Fed's responses will continue to dominate deliberations in Washington. In what follows, we look at the character of the Greenspan régime and, at greater length, what the pattern of responses has been and is likely to be.
By far the most interesting commentary we have seen on this matter has come from Paul McCulley of PIMCO. We have built our analysis around McCulley's answer to the question "Pyrrhic Victory?", his title for the September issue of his publication, FedFocus.
All of McCulley's essay bears careful reading, as it always does. The thrust of his argument revolves around his judgment that the Fed has finally decided to attack asset prices, and housing prices in particular. He quotes Greenspan's peroration at Jackson Hole to support this conclusion:
[C]ertainly, the exceptionally low interest rates on ten-year Treasury notes [Greenspan's "conundrum"], and hence on home mortgages, have been a major factor in the recent surge of homebuilding...and particularly in the steep climb in home prices....[T]here do appear to be, at a minimum, signs of froth in some local markets where home prices seem to have risen to unsustainable levels.
At the end of that paragraph, Greenspan utters the words, "with speculative fervor." As McCulley puts it, "That's about as clear as Greenspan ever speaks.
What troubles McCulley is not Greenspan's line of analysis and emphasis (who could argue with that?), but, rather, that Greenspan has put himself into the box of what economists describe as "time inconsistency." Once the policymaker is in that box, the world changes so that expectations about future policy reversals can undermine the power of current policy. Here is how McCulley sums it up:
Increasingly, it seems to me, the Fed's policy of threatening never-ending Fed funds hikes...so as to induce lower bond prices (higher bond yields) that will "get at" frothy property markets suffers from time inconsistency. Bluntly put, the Fed has a credibility problem, because the markets know...that the Fed's asset price policy is asymmetric....[That is,] ease vigorously and purposefully when bubbles confirm their existence by blowing up." [italics in original]
Alan Blinder's lengthy but fascinating appraisal of Greenspan's record at Jackson Hole describes this basic strategy as a "mop up after" strategy, which means the Fed will always reverse the pain of tight money at the end with a flood of fresh liquidity and lower interest rates.1 This phenomenon defines what has come to be known as the Greenspan Put.
A look at the track record
The graph shows the history of the Fed funds rate since 1954. Two features of this graph are immediately visible. First, the Greenspan Fed is by no means the first to reverse policy when money appears to be "too tight."2 Instead of following a straight line, from the very beginning the Fed funds rate has wobbled with a vengeance. Second - and more significant - the longer-term path of the Fed funds rate resembles the profile of a mountain, a point we have made before at some length and emphasis.
Both of these features raise serious questions about McCulley's case. The case itself has an inner logic leading to strange conclusions. The case is either off base or the world has become even more bizarre than we thought it was in the first place.
We must look at the Fed funds graph with some caution. Before Greenspan became Chairman of the Fed, the Fed funds rate was not much of a topic of conversation at Open Market Committee meetings. The chief focus was on member banks' excess reserves on deposit at the Fed, member bank borrowings at the Discount Window, and money supply measures. But the market for Fed funds has grown dramatically in more recent years, as banks have reduced the volume of their excess reserves and have relied more on borrowing from one another than turning to the Discount Window when they are short on reserves. Despite the limited importance of Fed funds in the early years, our graph still reflects the basic direction of monetary policy since 1954, its varying intensity, and the timing of the turning points.
The graph reveals that the unusual feature of the Greenspan Fed is not its willingness to be generous when the going is rough. They had plenty of company on that attribute. Whatever went up came down. Blinder's characterization of a "mop up after" strategy would apply equally to all these episodes, not just to the Greenspan episodes.
The remarkable anomaly in this history is the stability of the Fed funds rate from late 1994 to early 2000. The rate averaged 5.35% in that period, with a standard deviation of merely 37 basis points. For the entire period covered by the graph, the average rate was 5.74%, not far from 5.35%, but the standard deviation was a fat 336 basis points. A picture of the real Fed funds rate, adjusted for inflation, would make the change in the monetary environment since 1994 look even more extreme than it does here.
From our perspective, the Mountain shown on the graph has been a more potent force on interest rates and the nature of the economy than anything Greenspan and his colleagues have tried to accomplish. Note the remarkable symmetry in the graph: the Fed funds rate gains variability as it climbs the Mountain from the 1950s to the Volcker climax of 1981. Then it diminishes in volatility as it works its way downward in the years since 1981.
In short, the last fifty years have really been two worlds, entirely different from each other and demarcated by some odd coincidence almost precisely in the middle. The first half was a world in which actual inflation almost continuously exceeded inflation expectations. The second half was a world in which inflation expectations almost continuously exceeded actual inflation. This pattern had remarkable stability on both sides of the Mountain, regardless of which party was in power in Washington and regardless of who occupied the Chairman's chair at meetings of the Open Market Committee. Thus, many factors beyond monetary policy were at work in these years, such as the massive amount of liquidity and the humongous gold stock in the U.S. economy inherited from the end of World War II.
And there was one more force at work, displayed in the graph on page 4, a force that receives far less attention than it deserves. This demographic U reflects the baby boom in the left half and the maturing of the baby boomers and their impact on the size of the labor force on the right-hand side. Allowing for the lags that population changes will always bring with them, this graph is almost a precise inverse copy of the graph on page 3. This phenomenon has interested us for a long time. Many years ago, we explored the powerful influence of this demographic U on the path of productivity change, as labor force growth first slowed and then soared and then went flat. As a consequence of its influence on productivity, the demographic structure has played a dominant role in the rise and fall of inflation - and inflation expectations - in the U.S.
Alan Greenspan's most impressive achievement has been his recognition of this transformation and his willingness to adjust the rules of Federal Reserve policy to accommodate it. On the right-hand side of this history, when inflation kept coming through below expectations - and when financial globalization was gradually transforming the world around us at the same time - providing the system with sufficient liquidity became a higher priority than keeping the economy down until every last whiff of inflationary influences had been exterminated. This approach may have created the so-called Greenspan put, and it is easy with hindsight to nitpick it, but the Greenspan put has been, as bankers like to say, fundamentally sound in both concept and execution.
Nevertheless, Greenspan may be departing at a time when the basic paradigm is once again in the process of shifting, in two ways.
First, the ratio of people of working age to the total population has gone essentially flat - which is better than the declining ratio now taking place in some other countries. The U.S. has managed that shift up to now with a rate of productivity change that was remarkable by any standard. But there is good reason to believe the big surge in productivity change is behind us. From here on out, a slowly-growing labor force becomes a problem in managing the costs of production. At the same time, paying that labor force a sufficient real wage to buy the goods and services they produce only complicates the matter.
Second, the U.S. is running budget deficits and current account deficits that are destined to become unsustainable at some future point. The Federal Reserve has to function with those threats constantly before them. As America tips uneasily between smooth adjustment and catastrophic breakdown, a policy that has been essentially free of constraints from fiscal pressures and our external financial liabilities now has to take these perils into consideration.
What has all this to do with McCulley's case?
McCulley's case is not off base. Nor, really, is the world so bizarre. McCulley's case is incomplete, and what is missing has a lot to do with understanding the risks and rewards that may lie ahead.
We are confident McCulley would not disagree with our emphasis on the Mountain as an overwhelmingly important influence on the economic environment and the appropriate responses of the policymakers. But the agreement on where to put the emphasis appears to stop there. We have two problems. First, we find the argument about time inconsistency less than convincing. Second, with interest rates all the way down from the top of the Mountain they scaled in 1981, an entirely new perspective is in order, a perspective that fails to fit within the boundaries of the case McCulley has made.
McCulley points out that Greenspan is caught in the time inconsistency problem. Greenspan has been using a measured increase in Fed funds to push up the yield on long-term bonds in order to raise mortgage rates, his ultimate target. But he is doomed to frustration. Forward-looking investors will simply buy long bonds on the dips, confident that Greenspan will cut the Fed funds rate as soon as the housing boom crumbles. Easy pickings for investors. No sustained bear market in long bonds. No bust to the housing bubble
There is an implicit assumption in this case that needs exploring. Can it be that investors have only just woken up to a pattern that has been in effect for even longer than when J. P. Morgan observed that the market will fluctuate? Even those who experienced the agonies of the Volcker squeeze on the supply of money had to realize that Volcker was not going to cut the money supply down to zero. There would be a moment when the task would be done, when the money supply could start growing again, and when bond yields would go into reverse and start falling. Everybody knew that moment would arrive some day. Yet investors still let bond yields climb into the stratosphere. No buying on dips for those dopes! They chose to wait until Volcker saw the whites of their eyes at more than 14% in the fall of 1981.
Carried to its extreme, this doctrine leads to a curious conclusion. If long bond yields start to rise, investors will understand that higher rates will bring about conditions leading to lower rates, so they will not sell. If yields start to fall, investors will understand that lower rates will bring about conditions leading to higher rates, so they will not buy. Hence, bond yields will never change. Q.E.D.
In any case, I find it hard to believe that today's investors are so much more sophisticated and more psychologically aware of time inconsistency than the investors of yesteryear. Even William McChesney Martin mopped up, and he had declared inflation to be a more serious threat than communism. Today's investors are simply living in a different kind of environment. While the graph on page 2 demonstrates that what Blinder describes as a "mop up after" strategy is not unique to our time, the state of inflation expectations in our time is radically different from what it was in the old days. Long rates have dropped a thousand basis points below the 1981 peak and are now less than 450 basis points from zero.
Being down from the Mountain has a deeper meaning. The atmosphere on the terrain this close to zero is not like the atmosphere on a slope with a long way to go before it reaches zero. The same observation applies to the current rate of inflation compared to 1990, when it was in the area of 6%. Inflation since 1992 has averaged 2.6% with a standard deviation of only six basis points! Estimates of inflation expectations have followed suit. This set of condition bears no resemblance to the situation when the slope was still clearly downward. Indeed, the entire history from 1954 to 1992 may be irrelevant for forecasting what lies ahead.
From the beginning of this history in 1954 until the mid-1990s, the whole focus was on the rate of change - inflation is a rate of change, after all. But once investors became convinced that inflation had been washed out of the system and that any inflationary episode was likely to be brief and mild, the world's perspective becomes a view of a level rather than rates of change.
Under those conditions, mopping up is easy to foresee, and a bear market in bonds looks like a very low probability outcome. The point is an important one. What McCulley sees as a trap Greenspan has set for himself is a natural outcome of the sequence of events.
But beware! Even Greenspan cannot guarantee "those conditions" will persist into the indefinite future. On the contrary. This is the perfect environment for adverse surprises to have a tremendous effect. From this point forward, bets on mopping up should be hedged.
The hard part
What about the question in McCulley's title of "Pyrrhic Victory?" McCulley does not directly answer his question, but his view is apparent as he makes it a rhetorical question at the end of his analysis: "If, as Mr. Greenspan said in January 1998, risk premiums are 'lowest at price stability,' and if, as Mr. Greenspan said today, that 'history has not dealt kindly with the aftermath of protracted periods of low risk premiums,' was the achievement of secular price stability a pyrrhic victory?" [italics in original]
We step up to provide an answer. NO! History has not dealt kindly with the aftermath of protracted periods of price instability, to put it mildly. These italics are ours.
1 Blinder's paper, and all the others, are available at http://www.kc.frb.org
2 I cannot resist a great anecdote from the 1960s. The manager of the Federal Reserve's open market operation, Mr. Rouse, was appearing before a Senate committee and appraised current monetary policy as "tight, but not too tight." One member asked him back: "Mr. Rouse, could you also say policy is easy but not too easy?"
Peter would say he has forgotten more than most of us know, except at 80 plus years, he has not forgotten anything. I am proud to offer you his work today in Outside the Box.
Your seeing a new cycle in our future analyst,