Just Give Me a Framework! - The Return of PIMCO's Paul McCulley

Last weekend, after the whirlwind of the first week in my new job at PIMCO, I reread all my essays written during my previous incarnation here – some 120 of them. Yes, I have masochistic tendencies, which I will explore with my therapist, in hope those tendencies haven’t advanced to a disorder.

Don’t think so, as I was simultaneously listening to Pink: Just Give Me a Reason!

It was a very useful exercise, in part to remind myself of what I said and when I said it, so as to faithfully own my priors going forward. Not that I don’t have the right to change my mind. I am a devout believer of Keynes’ dictum that when presented with new information, a person has not just the right but the duty to change one’s mind. Or in the famous words of Ralph Waldo Emerson, a foolish consistency is the hobgoblin of little minds.

PIMCO is not a little-minds place, but rather a right-answer-wins place. And getting the right answer is often about being willing to openly recast one’s view of how the world works, in the context of one’s prior view, rather than passively dismissing it. There is no shame in recognizing new realities, only in refusing to do so.

• SPY 30-Year Financial Data
• The intrinsic value of SPY
• Peter Lynch Chart of SPY

War remembrances
In rereading my work of the first decade of this century, what struck me most was one unifying theme for the economy, policymakers and the markets: declaring victory in the War Against Inflation launched by Federal Reserve Chairman Paul Volcker in October 1979. Many of my new colleagues weren’t even born when that War started!

I could – but won’t! – go through the gory (wonky!) details of that War’s campaign. Suffice it to say that for two decades after Volcker’s initial assault, the Fed fought a secularcampaign against inflation with a cyclical strategy called “opportunistic disinflation.”

This strategy rejected the notion that the Fed should deliberately induce recessions to reduce inflation, but rather called for the Fed to “opportunistically” welcome recessions when they inevitably happened, bringing cyclical disinflationary dividends.

A corollary of this thesis was that the Fed should pre-emptively tighten in recoveries, on leading indicators of rising inflation, rather than rising inflation itself, so as to “lock in” the cyclical disinflationary gains wrought by the preceding recession.

Former Philadelphia Fed President Edward Boehne elegantly described the approach at a Federal Open Market Committee (FOMC) meeting in late 1989:

“Now, sooner or later, we will have a recession. I don’t think anybody around the table wants a recession or is seeking one, but sooner or later we will have one. If in that recession we took advantage of the anti-inflation (impetus) and we got inflation down from 4 1/2 percent to 3 percent, and then in the next expansion we were able to keep inflation from accelerating, sooner or later there will be another recession out there. And so, if we could bring inflation down from cycle to cycle just as we let it build up from cycle to cycle, that would be considerable progress over what we’ve done in other periods in history.”

Victory, and feeding Minsky
Opportunistic cyclical victories in the War Against Inflation became secular victory in the recession that marked the end of the century. The anti-inflation dog finally caught the price-stability bus. Indeed, a favorite day in history for me is 6 May 2003, when the FOMC, struggling to fuel faster recovery from the preceding “opportunistic” recession, formally declared victory (my emphasis):

“[T]he probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level. The Committee believes that, taken together, the balance of risks to achieving its goals is weighted toward weakness over the foreseeable future.”

Unwelcome. Yes, the FOMC declared, for the record, that any further fall in inflation would be unwelcome. There was no place lower for inflation the Fed wanted to go, and was worried that if the cyclical economic recovery didn’t get faster traction, deflationary pressures would emerge. At the time, the core CPI was running at a 1.5% year-over-year rate; it troughed a few months later that year at 1.3%.

And with that secular victory in the long War Against Inflation, not only did the doctrine of “opportunistic disinflation” die, but also its companion cyclical implementation strategy of “pre-emptive tightening.” What’s more, policy errors “on the side of tightness” would no longer carry welcome disinflationary silver linings. They would be mistakes!

Glowing with victory, the Fed celebrated the notion that it had fostered a Great Moderation, with long expansions and short recessions, a nirvana land of low cyclical economic volatility in the context of secular price stability. Concurrently, the Fed moved into a world of forward guidance, initiated with the FOMC telling the world explicitly, on 12 August 2003, that it would remain accommodative for a “considerable period” into recovery.

Without saying so explicitly, because it would have been politically incorrect to do so, the FOMC, by its subsequent actions, endorsed the notion that it would be acceptable for inflation to pick up somewhat in the unfolding expansion, in part simply to cut off the fat tail of deflation risk that had become all too real in the preceding recession.

And, to be fair to the FOMC, the next recession, now known as the Great Recession, was notthe result of excessive Fed zeal in cyclically fighting inflation. Where the Fed sinned, and indeed the whole mosaic of financial policymakers sinned, was failure to recognize that the whole concept of the Great Moderation would feed into Hyman Minsky’s Financial Instability Hypothesis!

As both private sector players and policy players believed and acted on the Great Moderation thesis, their very acts of doing so destroyed its viability, on the back of ever-more-risky privatesector debt arrangements – from Hedge to Speculative to Ponzi debt units, incubated in the explosively growing, barely regulated Shadow Banking System. And then the Minsky Moment hit in 2007–2008, ushering in a Liquidity Trap.

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