Shortly after PIMCO re-hired Paul McCulley as chief economist, Bill Gross revealed that he and McCulley had independently come to essentially the same conclusions about the New Neutral paradigm shaping the bond market. In his first article since returning, McCulley explains the New Neutral from his perspective, but he takes us back thirty-five years to do so.
The New Neutral: Volcker’s war on inflation
In 1979 Federal Reserve Chairman Paul Volcker declared a secular war on inflation using cyclical policy tools in what was called opportunistic disinflation. The idea was that recessions would inevitably happen from time to time, bringing inflation down with them, and the Fed would fight to prevent inflation from coming back when the economy recovered.
“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,” explains McCulley (emphasis his).
McCulley says the war was officially over on May 6, 2003 when the FOMC said that it was more worried about the possibility of deflation than it was of inflation. Secular inflation has been moving sideways since the late 90s, right around the Fed’s 2% target.
The New Neutral: The Taylor Rule and the Gordon Model
The Taylor Rule, which has guided central bank policy since it was formulated in 1993, sets a the long-term fed funds rate at 4% on the assumption of a 2% inflation target and a 2% real fed funds rate, and the Fed considers anything below this to be accommodative monetary policy. But McCulley and PIMCO believe that the real fed funds rate is actually around zero, and that the Taylor Rule’s outdated 4% guide is too high.
McCulley also thinks this change in the real fed funds rate explains why stock prices are higher than you might expect considering the state of the recovery. If you think that stock prices should theoretically be equal to the present value of all future dividends (McCulley specifically mentions the Gordon Model), then a drop in the risk-free long-term interest rate means that you apply a smaller discount to future dividends, and the present value rises.
“I don’t see current valuations for either bonds or stocks as ‘artificial’. They are not cheap, to be sure, because they have been discounting a lower equilibrium fed funds rate for quite some time,” writes McCulley.