“Uncle,” Uncle Alan, “Uncle!”

Where I grew up in the South during the ‘50s and ‘60s, corporeal punishment of children was not only socially acceptable, but deemed to be a divinely-inspired parental obligation: Spare the rod, spoil the child. Many who grew up in such a disciplinary regime, which would now be called child abuse, muse that they are none the less for it, and perhaps even the better for it.  I don’t share that view.  To the contrary, I believe that beating of children is beating of children, and that the emotional scars of such beatings last a life time.

You may disagree, and I respect you for that. I do, in fact, believe in the disciplining of children; and adults, for that matter. I do not, however, believe that the rod is the proper method. Indeed, the corporeal punishment regime of my youth was actually, and perversely, an early education in the art of lying.

• A whipping at school (yes, that was legal!) by definition implied misbehavior so grievous that it warranted a follow-up whipping at home. I never understood this – a flogging as justice for having received a flogging? Therefore, I learned to lie about any whippings received at school, an entirely logical, even if immoral, response.

• Fighting amongst siblings warranted a flogging, regardless of which sibling may have “started it.” I never could understand the justice of this dictum, for the simple reason there was none. I did, however, learn that if the same punishment was going to be meted out to both the guilty and the non-guilty, it made sense to be guilty; and then lie about it, of course.

• A stoic, silent acceptance of a flogging was evidence that the flogger was not applying the rod with sufficient vigor. After all, a proper flogging was supposed to elicit pain, and therefore wailing and gnashing of teeth. Breaking the code on this matter, I learned to scream like hell in response to the first blow of the rod. If evidence of pain was the necessary condition for ending the infliction of pain, it was logical, even if immoral, to pre-emptively lie about the degree of one’s pain.

I could go on and on. But I won’t. Over the last forty years, society has evolved to more enlightened thinking on the whipping of children, and for that I’m grateful. In contrast, society has retrogressed in its thinking about monetary policy, and now openly embraces corporeal punishment as practiced by Federal Reserve. More specifically, society accepts that the Fed has the right to preemptively apply tight money, even if there are no obvious signs of a nasty acceleration in inflation, if the Fed deems that too many citizens have jobs for their collective non-inflationary good.

Fed officials would, no doubt, deny doing any such thing of the corporeal sort. The official line at the Fed is that job creation is to be celebrated, and that the Fed wants the highest possible “sustainable” level of employment and the lowest possible “sustainable” level of unemployment. But like adults applying the rod to children, the Fed gets to decide the meaning of “sustainable.” And again like adults bearing the belt, the Fed doesn't necessarily feel any obligation to define its meaning of “sustainable,” even after it has presumably decided – it is what it is, ‘cause we say so!

As Go Firings, So Goes GDP

The Vigilance Began on July 3, 1996
Ever since the easing-cum-soft landing of 1995, the FOMC, as a body, has been unhappy about the falling unemployment rate. When not constrained by depressions in the emerging markets and/or the blowing up of hedge funds in the Republic of Greenwich, Connecticut, the Fed has been consistently “vigilant” in favoring monetary restraint with the explicit objective of tempering job creation.

This vigilance commenced at the July 3, 1996 FOMC meeting when, with the unemployment rate at 5.6%, the Fed adopted a bias to tighten. The rationale:

“While a strong economy generally was a welcome development, at current levels of resource use a continuation of rapid growth was not likely to be sustainable because it would have the potential for adding significantly to inflation pressures.”

Implicitly, the FOMC was declaring the prevailing 5.6% unemployment rate to be the NAIRU, or non-accelerating inflation rate of unemployment. To be sure, the FOMC didn’t say that, but rather voiced a concern that continued rapid growth would elevate still further “current levels of resource use.” To wit, rapid growth would push the unemployment rate lower! The FOMC implemented that bias by tightening at its March 25, 1997 meeting, when the unemployment rate stood at 5.3%. The rationale:

“Continued growth near, or even somewhat below, the recent pace would raise resource utilization rates further from their already high levels. Although labor markets already were tight, inflation had remained relatively subdued, and there were no signs in price data that it was picking up. However, the risks of a rise in inflation down the road had increased appreciably as a result of the strength of aggregate demand and the increase in pressures on resources that likely would accompany it absent a firming in financial conditions.”

The FOMC was clearly ticked that the “labor markets already were tight” and was worried that they would become tighter still. That is, the unemployment rate would go lower still! After tightening at that March 25, 1997 meeting, the FOMC dropped its bias to tighten. But then the FOMC re-adopted the bias at its very next meeting on May 20, 1997, when the unemployment rate was at 4.9%. The rationale:

“The members found it very difficult to account for the surprisingly benign behavior of inflation in an economy that had been operating at a level approximating full employment – indeed, possibly somewhat above sustainable full employment in labor markets in the view of a number of members, especially taking into consideration the recent further decline in the unemployment rate. On the basis of historical patterns, any overshooting of full employment would be expected to generate rising inflation over time.”

In a rare bout of honesty and clarity, the FOMC was actually willing to talk about its sense of “full employment,” and the possibility that the economy either had, or would “overshoot full employment.” To wit, the possibility that the economy either had, or would undershoot the NAIRU – too few unemployed! The bias to tighten remained in place until the December 16, 1997 meeting, when it was begrudgingly dropped out of deference to the perfect storm gathering in Asia, even though unemployment had fallen to 4.6%. But it was a most wimpy move to a neutral stance. The rationale:

“A majority of the members indicated a preference for a shift to a symmetrical directive even though many continued to anticipate that the next policy move was likely to be in a tightening direction. Other members expressed a slight preference for retaining a directive that was tilted toward tightening. In their view, such a directive would continue to underscore their concern that at current and prospective levels of resource utilization, rising inflation was the most serious risk to the economy.”

The FOMC was clearly still ticked about “high levels of resource use, notably in labor markets.” And “many” of the members who favored ditching the bias to tighten openly admitted that they still thought the FOMC’s next move would be to tighten. Thus, the removal of the bias to tighten at that FOMC meeting was a public relations exercise, not an economic policy exercise. Confirming that thesis, the FOMC readopted the bias to tighten at its March 31, 1998 meeting, when a deflationary depression in Asia was clear for all to see, but the unemployment rate was still hanging at 4.6%. The rationale:

“As they had at previous meetings, members expressed particular concern about the outlook for prices in the absence of appreciable slowing in the growth of aggregate demand, which appeared to be adding to pressures on labor resources. The members agreed that should the strength of the economic expansion and the firming of labor markets persist, policy tightening likely would be needed at some point to head off imbalances that over time would undermine the expansion in economic activity.”

By the Fall of 1998, of course, the FOMC had to suspend corporeal punishment of the economy’s job creation, out of deference to dysfunctional markets in the wake of the Russian default and the blow-up of Long Term Capital Management. At the August 18, 1998 FOMC meeting, the Committee ditched its bias to tighten, and then actually eased at the following meeting on September 29,1998. The FOMC also adopted a bias to further ease, which was implemented off-meeting on October 15,1998. The FOMC eased one last time at its November 17, 1998 meeting,when it shifted from a bias to ease to a neutral stance. The unemployment rate stood at 4.5%. What a great time to be working for a living in America!

But not at the FOMC, which never, ever wanted to ease with a 4% handle on the unemployment rate. And so, at the FOMC meeting on May 18, 1999, when the unemployment rate stood at 4.3%, the Committee readopted a bias to monetary flogging. The rationale:

“In light of the persistent strength in domestic demand, the reduced risks of economic weakness abroad, and the recovery in US financial markets, most members believed that for the year ahead the odds around their forecasts were tilted toward further robust growth that would add to pressures on already tight labor markets.”

At every meeting since, the FOMC has either tightened, bellowed a bias to tighten, or both. And consistently, the dominant rationale has been low unemployment. Such was the case when the FOMC last tightened at its May 22, 2000 FOMC meeting, when the Committee doubled the force behind the cane, hiking the Fed funds rate 50 basis points to the prevailing 6 1/2% level. Even after that “aggressive” move, the FOMC retained a bias to further monetary caning. The rationale:

“The members agreed that the balance of risks sentence that would be included in the press statement to be released shortly after this meeting should indicate, as it had for other recent meetings, that even after today’s tightening action the members believed the risks would remain tilted toward rising inflation. This view of the risks was based primarily on the persisting momentum of aggregate demand growth and the unusually high level of labor resource utilization.”

The bias to tighten remains in place, of course, as the FOMC revealed following its November 15, 2000 meeting:

“The utilization of the pool of available workers remains at an unusually high level, and the increase in energy prices, though having limited effect on core measures of prices to date, still harbors the possibility of raising inflation expectations. The Committee, accordingly, continues to see a risk of heightened inflation pressures. However, softening in business and household demand and tightening conditions in financial markets over recent months suggest that the economy could expand for a time at a pace below the productivity-enhanced rate of growth of its potential to produce.

Nonetheless, to date the easing of demand pressures has not been sufficient to warrant a change in the Committee’s judgment that against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the risks continue to be weighted mainly toward conditions that may generate heightened inflation pressures in the foreseeable future.”

The Beating Will Continue Until Job Insecurity Rallies
Wall Street read this FOMC statement as a bias to remove the bias to tighten. I agree with that assessment, though I think the notion of the Fed having a bias to have a bias, or a bias not to have a bias, is starting to slice the policy baloney just a little bit too thin. But since the FOMC owns the tools of corporeal punishment, we in the financial markets have to listen to what they say, even if we think it is silly – like that nonsense I heard when I was a child that somehow a flogging was going to hurt the flogger more than me!

I believe that it is indeed highly likely the FOMC will formally ditch its bias to tighten at the December 19, 2000 meeting, and if not then, certainly at the January 30-31, 2001 meeting, the last one before Chairman Greenspan's semi-annual testimony before Congress (formally known as Humphrey Hawkins). After all, it would be difficult to explain maintaining a threat of further overt flogging of the economy,when the flogger himself admits that the floggee is suffering serious pain.

So, let's assume the bias to tighten is history. The real issue, then, is: When is the FOMC going to adopt a bias to ease, and then, actually ease? As I see it, the FOMC effectively just answered that: When the unemployment rate has gone up! The FOMC (1) admitted that it remains wrapped around the axle of “the unusually high level of utilization of available workers,” and (2) admitted that the economy “could expand for a time at a pace below its potential growth.” By definition, “potential growth” is that which holds the unemployment rate constant. Thus, if the economy is going to expand below potential “for a time”, it is a tautology that the unemployment rate will go up.

That, I submit, is exactly what the FOMC wants. Otherwise, the FOMC would have taken action to ameliorate the “tightening conditions in financial markets” that augur for “below potential” growth. To wit, it would have ditched its bias to tighten! But it didn’t. So, by logic, we can conclude that the FOMC will not be willing to ease, actually ease, until unemployment has gone up.

I expect precisely that outcome in the months/quarters immediately ahead. Monetary restraint “works” by (1) inducing “tightening conditions in financial markets,” which (2) trigger a deceleration in aggregate demand, which (3) triggers further “tightening conditions in financial markets” via negative profit and credit effects, which (4) trigger a slowdown in private sector hiring and an acceleration in private sector firing, which (5) trigger a rising unemployment rate.

The first four steps in this causal chain are already well in train, so forecasting the fifth, a rising unemployment rate, is not particularly a bold forecast. In fact, a forward-looking FOMC that was content with the prevailing unemployment rate would use such a forecast to “justify” putting away the rod of monetary restraint. In contrast, an FOMC that actually wants a higher unemployment rate would do exactly as the FOMC is doing – continue to flog, I mean flag, inflation risks even after it implicitly forecasts rising unemployment!

All of this says to me that (1) the FOMC is willing to skirt a lot closer to recession than the consensus believes; (2) actual easing is going to be slow in coming, even after the FOMC ditches its tightening bias; but (3) once the unemployment rate has risen “sufficiently” to induce the FOMC to bring itself to easing, it will ease a lot.

The Bottom LineI believe that in 2001, the unemployment rate will rise to at least 4 1/2% and that the Fed will ease to at least 5 1/2% Fed funds . I say “at least” because I think the FOMC is playing a very, very dangerous game. If a central bank waits to ease until proceeding tightening shows up in the lagging variable of unemployment, it runs the distinct risk of inadvertently inducing a recession.   

For investors, I think the implication is clear: Resist betting on monetary reflation until the unemployment rate goes up. More specifically, resist the urge to front run Fed easing by loading up on high P/E stocks and low quality bonds. Yes, those are the most “levered” assets to Fed easing. And if the Fed was content with the prevailing unemployment rate, as was the case in the easing-cum-soft landing of 1995, I would be pounding the table to buy them. Now, however, the Fed wants a higher unemployment rate.

There will be no “I’m sorry” ice cream from the Fed until there are visible welts on the buttocks of the labor market.

Paul McCulley
Executive Vice President
November 28, 2000