PIMCO chief economist Paul McCulley has been arguing that the Federal Reserve will keep the Fed funds rate low until labor finally gets a share of the recovery in the form of real wage growth, and in this month’s wide ranging Macro Perspectives he gives a more detailed explanation of the mechanism that he sees at play.


Dornbusch explains exchange rate movements

Going back to the mid-70s when Bretton Woods was still a recent memory and economists were making sense of floating exchange rates, McCulley says that the work of Rudi Dornbusch to explain why exchange rates weren’t behaving as expected can shed light on our current predicament.

After Nixon ended the Bretton Woods system of fixed exchange rates by taking the US off the gold standard, economists had expected floating rates to match changes in purchasing power parity (PPP) in real time, correcting for trade imbalances and other market forces. In practice, that didn’t happen and exchange rates regularly differed from what you would have predicted based solely on PPP.

What Dornbusch realized was that the discrepancy was due to the different time frames of Wall Street and Main Street: traders might be able to adjust to changing conditions at the drop of a hat, but businesses couldn’t. That meant, for example, that if a central bank tried to combat an overvalued currency with a quick change to monetary policy, financial markets would respond more quickly than inflation is able to and the only way to get investors to buy bonds during this transitional period is if the currency becomes undervalued on a PPP basis.

‘Rationally overvalued’ stock prices aren’t a bubble, says McCulley

McCulley argues that the same time lag is what’s forcing the Fed to keep rates low far lower than you might expect by only looking at financial markets.

“When a Liquidity Trap hits, the Fed is in a pickle. The Fed can take its policy rate to the Zero Lower Bound (ZLB), but it will not generate a revival of either increased demand for or supply of bank credit and, in lagged train, upside action for prices and wages on Main Street,” he writes. “Such is the nature of monetary policy in a Liquidity Trap, which is akin to the position of a cheesecake vendor at a convention of recovering overeaters: The customers ain’t buying, even though they are known to like the product, and the price is zero.”

The other option, one that McCulley says shouldn’t even be considered if the fiscal authority (Congress) were taking action, is to get out of the liquidity trap is to inflate the value of the assets being used as collateral, restoring the balance of debt to equity. Keep Wall Street prices high for long enough and Main Street prices will follow suit, but just like with exchange rates, the faster moving Wall Street prices will necessarily overshoot during the transition period.

McCulley’s conclusion is that financial assets are rationally overvalued, responding to a real time lag in the economy, but that we shouldn’t conclude that we are in the middle of an asset bubble. When wage growth eventually picks up, Fed policy will adapt and the ‘rationally overvalued’ stock prices will adjust in turn.