Thursday, September 04, 2008
Paul McCulley and Bill Gross at Pimco are on quite a roll so far this month.
The duo write widely read monthly commentaries that appear around the first of the month and, given their latest offerings, they were probably both chomping at the bit earlier this week, perhaps bickering over which one would appear first.
It really wasn't a close call. Coming off of the heels of last year's coinage of the term "shadow banking system", now in broad usage, McCulley seeks to recharacterize Federal Reserve inflation hawks as something less flattering.
After attending the Kansas City Fed's annual Jackson Hole Symposium, McCulley penned In the Fullness of Time, taking aim at the "inflation nutters" (a.k.a., inflation hawks) at the Fed who can't see past (or, "through" would probably be a better word) their inflation data, failing to "get" the underlying problems in the U.S. and world economy.
The hawks scream that the Fed must tighten sooner rather than later, so as to burnish the Fed’s anti-inflation credibility, but do so without any discussion whatsoever of the monetary policy transmission mechanism; they simply look at the negative prevailing real Fed funds rate and say it’s too damn low and should be raised.Well, monetary laxity in the current era is a given, not even worth arguing over, really, and moral bankruptcy should probably be left to the historians. What's at issue here is looking past the inflation data in an attempt to avoid a global economic downward spiral that seems to get worse, not better, every month. Perhaps a better measure of "inflation" would help (see The complete and utter failure of owners' equivalent rent).
Really, that is essentially their entire story. The only good thing about their story is that it is so easy to refute using standard macroeconomic and finance theory. But unfortunately, not even that seems to get them to shut up.
All sensible discussion of the “right” real Fed funds rate logically must begin with the proposition that the putative “neutral” equilibrium real Fed funds rate is not constant, but rather time varying, a function of financial conditions, notably whether levered financial intermediaries – conventional banks, as well as shadow banks, a term I coined last year at Jackson Hole – are ramping up or ramping down their leverage. The former will lift the “neutral” real rate while the latter will reduce it. Thus, a high Fed funds rate may not be restrictive at all while a low Fed funds rate might not be stimulative at all.
This should be a self-evident truth, but somehow, it hasn’t penetrated the gray matter of the inflation nutters, who view a negative real Fed funds rate as prima facie evidence of monetary laxity at best, and moral bankruptcy at worst. It is not.
In There's a Bull Market Somewhere?, Gross once again advocates the use of taxpayer money to help prop up the asset-based financial economy that we have all grown to love so. Home prices that continue to fall and the dearth of new money to provide a backstop are problems that are getting worse not better.
This rarely observed systematic debt liquidation is what confronts the U.S. and perhaps even the global financial system at the current time. Unchecked, it can turn a campfire into a forest fire, a mild asset bear market into a destructive financial tsunami.Where the Treasury gets the money is a problem left for another time, apparently.
To ultimately stop this asset/debt deflation, a fresh and substantial new source of buying power is required. This became all too obvious as the Treasury’s attempt to entice additional capital into Freddie and Fannie came up empty. Yet this same dilemma is and will continue to confront all highly levered institutions in the throes of asset liquidation.
If we are to prevent a continuing asset and debt liquidation of near historic proportions, we will require policies that open up the balance sheet of the U.S. Treasury – not only to Freddie and Fannie but to Mom and Pop on Main Street U.S.A., via subsidized home loans issued by the FHA and other government institutions.
The bill for our collective speculative profligacy, obvious in the deflating asset markets, can be paid now or it can be paid later.
Interestingly (and related to the question of where the Treasury gets the money), the Bond King references Jim Grant of Grant’s Interest Rate Observer to assist in answering the question posed in the title, namely, "there's a bull market somewhere?"
Mr. Grant argues that government solutions for the current economic and financial market woes, such as the ones proposed, are likely to lead to a new bull market in ... gold.