In his House testimony last week, Fed Chairman Alan Greenspan addressed the subject of a rate of interest that would keep inflation down without slowing the economy. He is talking about the federal funds rate, which now is the only tool that the Federal Reserve has to manage the price level and the economy. What is that “natural rate,” or as some say “neutral rate?” Greenspan admitted that he did not know what it is, but that he would know when we get to it. There is no bigger question hanging over the financial markets, here and around the world, yet there is scarcely any discussion about it. If Maestro Greenspan does not know what it is and does not even have a theory on how it might be discovered, how can mere mortals divine that natural rate? I have prodded a number of economic correspondents to take up the challenge, to dig into this question, because Fed policy is now directly affecting how business is being conducted everywhere the U.S. dollar extends its reach. Why does it have to be any higher than 1%, where it was last month? I am becoming convinced that before the national news media takes notice, it will take President Bush or Senator Kerry to ask aloud what the heck this is all about.
At least we can thank Paul McCulley, chief economist of PIMCO in Newport Beach, CA, for challenging the notion that one can find the “natural rate” by averaging the funds rate over a cycle or two. In a speech he gave in Switzerland last month, he decried the absence of a definition to the search for a neutral funds rate and proposed a rule of his own design.
Earlier this month, McCulley gave an interview that elaborated on his proposal, which he acknowledges is impractical. The proposal merges monetary and fiscal policy in an elaborate formula that is mind numbing in its complexity.
Still, although a bit cheeky, McCulley has been getting considerable attention if only because he is asking the right questions and has some standing, given PIMCO’s zillion-dollar bond portfolio. Here is the pertinent exchange with Kathryn Welling, the interviewer:
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WELLING: But, you want more. Not just a definition of inflation—
McCULLEY: That’s the big issue for me because everything else gets confused and cloudy without a definition. We need a definition, as I’ve been saying, to spark the appropriate debate about how wide the band should be, cyclically, around that definition. Number two, and this is more contentious, is that 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, hold on, by definition, 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. Which is just not happening. Everyone is just assuming that it is 2%-to-3%, as Professor Taylor told us years ago.
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Here McCulley refers to John Taylor of Stanford, who devised the “Taylor Rule,” which rests on a monetary formula that McCulley correctly dismisses as being obsolete. Taylor, in turn, most probably developed his “rule” on the intellectual foundations of a Swedish economist of the late 19th and early 20th centuries, Knut Wicksell. Here is the opening paragraph of Wicksell’s 1906 tract on the influence of interest rates on prices:
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The thesis which I humbly submit to criticism is this. If, other things remaining the same, the leading banks of the world were to lower their rate of interest, say 1 per cent below its ordinary level, and keep it so for some years, then the prices of all commodities would rise and rise and rise without any limit whatever; on the contrary, if the leading banks were to raise their rate of interest, say 1 per cent above its normal level, and keep it so for some years, then all prices would fall and fall and fall without any limit except zero. Now this proposition cannot be proved directly by experience, because the fact required in its hypothesis never happens.
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What is going on here? Quite simply, it goes back to Greenspan’s comment last week to Rep. Ron Paul [R-TX] that he believes central banks can “replicate” a gold standard by managing interest rates, that fiat money need not be inflationary. What Wicksell was hypothesizing a century ago was a fiat money world, which is why he observed that his proposition could not be proven. Under the gold standard that covered the world back then, the price of gold was fixed and the market found the rate of interest that would prevent commodity prices from going up or going down (i.e., the natural rate). It was sometime in the 1980’s that Wicksell’s hypothesis was revived by Fed Governor Manley Johnson, as I recall, when an idea was needed to explain the monetary deflation that appeared on and off from 1980 to 1985. Inflations and deflations could be prevented if only you could, absent a commodity price rule, figure out where the natural rate of interest would be at any given time. If the market knew how the Fed would locate that natural rate, monetary risk would recede and there would be stable prices with more rapid growth than might be the case otherwise.
The basic flaw in using Wicksell, though, is that in his day the “natural” rate was the long-term lending rate. There was no Fed to monetize government bonds and there was no equivalent of an overnight funds rate to meet reserve requirements. The market today – for both government and corporate bonds – does find the “natural rate” for bills and bonds, to a large degree influenced by the funds rate. The argument that we have been making at Polyconomics is that if Greenspan were really interested in replicating a gold standard – to take as much risk out of the money as possible – he would replicate the gold-standard interest rates that we enjoyed in the years before we gradually abandoned Bretton Woods and its commitment to $35 gold. At the peak of Bretton Woods rule in 1958, the funds rate was 1%. Only after the government began to push the Fed in 1958 toward “easier money” to move the economy into higher gear did the funds rate move up, to 1.25% by 1962.
It also is a dubious proposition that managing the funds rate can prevent inflation or deflation. Both are monetary events, where prices go up or down because of an excess or dearth of liquidity. Raising the funds rate is implicitly an increase in the cost of capital designed to slow the economy, reflecting the Fed’s concern that inflation will occur if the pool of available labor dries up. In an e-mail to me, PIMCO’s McCulley observed that the Fed is always and everywhere worried about too many people working. Indeed, in his public statements, McCulley cites Karl Marx, who found capitalists always wish for “a reserve army of unemployed” to keep wages in check. If the Fed does raise the funds rate again and again this year in search of a natural rate, it will only get further and further away from the gold-standard-like yield curve we have been enjoying, all the while pushing up the cost of credit.
In other words, you cannot drive down the price of apples by fixing the price of borrowing a bushel of apples from the supplier. Nor can you fix the price of apples by controlling the supply of peaches. Temporarily and painfully, the supplier of peaches could flood the market with them at distress prices, causing consumers to shift from apples to peaches, but once the peaches are gone, consumers will return to apples at the old price. This is the difference between “contraction” and “deflation,” the flip side of the difference between “expansion” and “inflation.”
What puzzles many of you is why the Fed does not simply fix the dollar/gold price instead of trying to “replicate” its mechanism by probing for the right funds rate. We go back to McCulley’s point that the Fed’s natural bias is against too few workers. I have made this point many times over the years, noting that the Fed as an institution is run by people who are attuned to the needs of corporate America, not entrepreneurial America. It is not a populist institution. The presidents of the 12 regional Feds are plugged into the mature business communities in their districts, not the scrambling entrepreneurs at the bottom who compete for the employment pool.
The people who benefit most from a commodity-based monetary rule are those on the bottom. The Fed must supply all the liquidity being demanded at that fixed price. There then can be no inflation or deflation, but there is also no way to manage the employment pool. Octopus Inc. has to compete for available labor. Given the lower cost of capital, in many cases they will find top employees quitting to start their own competing companies. The same phenomenon exists when there is a choice between lowering the capital gains tax, which primarily benefits the entrepreneurial class, and lowering the tax on dividends, which primarily benefits the corporate class. Richard Nixon, who was owned by the corporate class, not only took the country off the gold standard, but also doubled the capital gains tax, with the Business Council pushing in that direction. The Reagan presidency was the antidote to the excesses of corporatism.
Where are we today? Obviously the corporatists are back and have been for some years, with deep hooks into both major political parties. Which is why it is so important right now, in this political year, to debate monetary policy and the natural interest rate.
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