A Chat With PIMCO's Paul McCulley

The fixed-income maven holds forth on the recovery, inflation and Fed tightening.
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When PIMCO's Bill Gross talks, all of Wall Street pays heed. At least, prudent traders do, as PIMCO manages more than $250 billion in fixed-income assets, and Gross' track record is legendary. Increasingly, similar deference is being given to Paul McCulley, who works side by side with Gross as a managing director and overseer of PIMCO's short-term securities, which recently totaled $90 billion.The following interview occurred prior to Federal Reserve Chairman Alan Greenspan's testimony Wednesday morning. McCulley forecast -- correctly as it turned out -- that the chairman would dampen expectations for tightening, as reported here. Today, McCulley had the following comments about Greenspan's testimony:

"Greenspan is bartender-in-chief for the New Age Economy, and likes a bar full of happy students. He declared happy hour prices last fall, and is most pleased with himself that the American consumers have continued imbibing, particularly for the house drink called 'housing.'

Greenspan concedes that maybe he will someday end happy hour prices, but has no intention of doing so until he is assured that the student body ain't gonna up and leave the tavern. In the fullness of time, there will come a time when he will tighten. But time ain't yet full."

You'll find more of these insights and witticisms in the following question and answer session. Part one of the Q&A deals with the economy, inflation and the outlook for Fed policy. Part two, to be published later, deals with issues of corporate governance, bondholder activism and the fallout from PIMCO's recent comments about General Electric (GE) - Get Report. Enjoy.

Task

: Let's begin with your thoughts on the state of the economy. At what point of the recovery are we right now? Do you agree with Treasury Secretary O'Neill's comments Monday that the U.S. is "poised for a return to robust growth."

McCulley

: I think the economy is unambiguously in recovery. We've moved from the dark side to the sunny side of the inventory cycle. That's a process of addition by the elimination of subtraction. I think also the worst of the blowing up of the investment bubble is behind us, so it's still the case of addition by elimination of subtraction: You feel better when you quit banging your head up against the wall. But I don't think it's heading for robust economic growth.

Task

: Why aren't you as optimistic as the Treasury secretary?

McCulley

: Notwithstanding the fact that we have reached the bottom, and turned on the inventory side, I think the dominant two reasons that you won't have robust recovery are the lack of recession in the household sector, and the extended workout in the corporate sector associated with its balance sheets. Or as I put it around here, corporate America has checked itself into the Betty Ford Center for balance sheet repair.

I think Mr. Greenspan deserves a pat on the back for keeping the household sector moving along, but as a matter of arithmetic you can't have a recovery from a cyclical peak. Prospects for robust recovery are muted by the fact that it was not a nefarious, broad-based type of recession.

Task

: It doesn't sound like you share the view that the inventory cycle will be self-sustaining and generate a so-called virtuous cycle.

McCulley

: In some respects the turn in the inventory cycle is again a case of addition by the elimination of subtraction. When companies are actually liquidating inventory it is a massive drag on industrial production. Just stopping the process of liquidation is a tremendous positive because liquidation is a negative in the GDP equation. However, I don't think you are going to see robust rebuilding

of inventories. I think the follow-through from the sunny side of the inventory cycle however will be limited because it is in the context of companies trying to rehabilitate their disclosure as well as their balance sheets. They're normal cyclical dynamics that are going on, but it's not rye bread, it's more like white bread -- with Miracle Whip on it, not mustard.

Task

: How do you think that is going to translate into Fed policy? Bill Gross wrote at the

PIMCO site, that he expects the Fed will raise the fed funds rate to 3% by the end of this year. You recently forecast the fed funds rates will double by the end of 2003. So it sounds like you're in agreement with a timetable of tightening that is sort of front-end loaded?

McCulley

: He is talking about 2.5% to 3% by the end of this year, and I'm talking about 3.5% by the end of next year. There is not any material difference there on the scheme of things. The essence of the whole deal is the Fed wants to take back some of the easing that it did after Sept. 11. Once it finishes that process of getting back to where it was prior to Sept. 11 then it will declare itself to be "neutral" and there is not much to be done thereafter.

As you probably can tell from my piece, I find the whole language that the Fed uses about 'taking back easing' to be a crock, quite bluntly. Tightening is tightening and it involves restricting liquidity, and restricting liquidity is not good for risk assets, particularly stocks. The precise moment that they start that process is less important than the rationale for what they are doing. Bill and I share the same view on this.

Task

: I wasn't trying to imply that you were in disagreement. It was more of the question of the timing of when you see the rate hikes happening.

McCulley

: I think they will start the tightening process before the end of this year. Bill, and I are not religious about the notion of 3%

fed funds by the end of this year vs. 3.5% by the end of next year. What we are religious about is that the Fed, being inherently anal, wants to get back to essentially where it was before Sept. 11, and I think there are binding constraints on the Fed's ability to do that. If we're wrong on our rate forecast I think it will be that we're too pessimistic about the prospect for monetary policy tightening. I think Greenspan needs to have a preponderance of evidence to tighten monetary policy, unless he can come up with some means to tell us that he knows when to say when.

He has a very nasty legacy that he is dealing with that I touched on in the cover graph in my April Fed focus, which is that coming out of the 1993 episode they said they had to get back to being neutral, and then coming out of the 1998 easing, in 1999 they said they wanted to get back to something that is more neutral. The Fed has zero credibility of knowing when to say "when" once they start tightening. Therefore the act of tightening, and the first step, leaves the marketplace to want to discount a pretty messy process, because the last two times we got into that it was with a bulldog.

Task

: I think because of that history a lot of people in the market are very concerned about the precise moment tightening will begin, even though you think it is less important than the reasons why. When do you think it will happen?

McCulley

: I don't think it will be before the Aug. 13 FOMC meeting, which would be after Humphrey Hawkins, after we've gotten the second-quarter type of data, and potentially after we got a bit more of the uncertainty cleared up with respect to what's going on in Palestine.

Task

: Any thoughts on how the latest developments in the Middle East will affect the market?

McCulley

: The marketplace doesn't know how to forecast the outcome of what is going on there. But it does know that it involves an additional measure of risk for both the economy and for risk assets. What

traders do know is it means more uncertainty, and to the extent that you have uncertainty, and you're just in the nascent stages of economic recovery, these unfortunate events have the potential for keeping the economy weaker for longer and therefore keeping the Fed on hold for longer.

Task

: That raises another issue that I wanted to ask you about -- whether or not you see there being any risk of a so-called double dip?

McCulley

: I don't think there is much risk of that. My way of thinking is you would only have a double-dip recession in one of two scenarios. One is an unfortunate terrorist war event that is totally unpredictable, but such an event that would effectively freeze economic agents globally. The other scenario would be a colossal screw-up on the part of central banks of wanting to take back easing, and in the process of doing so generating another pervasive round of risk aversion that aborts the ongoing rehabilitation of corporate balance sheets, knocks the stuffing out of equities, blows out credit spreads, and just in general creates a big mess.

Task

: There are a lot of people who are very critical of the current central bank head. He's swung from a series of crises, has overreacted in both tightening and easing in his career. How much confidence do you have in the chairman at this point?

McCulley

: I tend to be on the dovish side of things so I'm a whole lot more forgiving of overreacting on the easing side vs. the tightening side. I don't necessarily look at those things as symmetric. But I do worry about an overreaction on the tightening side certainly, and that would be a path toward double dip. Again I'm not forecasting a colossal mistake by the Fed, but it is a risk. I'm actually quite happy that Mr. Greenspan is there because he does have the ability to say 'no' to that committee. That committee is congenitally more hawkish then he is. Always has been.

Task

: Sounds like they're more hawkish than you are, too.

McCulley

: Absolutely. We've been fighting inflation for 20 damn years

and we've reached price stability. In the rank order of things of what ails America, inflation just ain't at the top of the list. Twenty years ago, it was enemy number one. Anyone who thinks the risk of rising inflation is enemy number one today is doing something stronger than Marlboros.

Task

: I guess that puts me in that category.

McCulley

: That's OK as long as you share.

Task

: Still, you are forecasting a rise in inflation: Do you think it will prove damaging to the equity markets?

McCulley

: In some respects it depends on how the fixed-income market reacts to it, and how the Fed reacts to it. A cyclical increase in inflation because companies have slightly more pricing power is actually bullish for corporate profits. Whether or not it's bullish for the equity market depends on the valuation basis, because stock prices are both 'E', as well as P/E, and a little bit of restoration of corporate profit margins with better passing is good for E. Whether or not it is bad for P/E really is a function of what kind of inflationary risk premium you can put in the long run of the

Treasury curve and what the Fed does with real short-term interest rates. Whether a little bit of pricing power on the part of corporate America would be bullish or bearish for stocks really depends on the verdict of the fixed income market, and the Fed. I think that Greenspan doesn't want to see an improvement in corporate profits be greeted with a colossal slap for stock prices because he's tightening monetary policy. I think Greenspan wants stocks to go up.

Task

: I think so, too. But what you've described to this point -- a muted recovery, limited inflation risk, a Fed hesitant to tighten -- would on the surface make me think you and PIMCO are very optimistic about the long end of the curve. But that is pretty much the opposite of what Bill Gross recently wrote at the firm's Web site.

McCulley

: We are decidedly milquetoast in our entire outlook about the Treasury curve. It's pretty steep right now and we would imagine it will probably remain steep. That's pretty consistent with what Bill had to say.

Task

: He wrote: "Short-term rates are even more critical to the profitability of Corporate America -- to the level of the stock market -- to the growth rate of the American economy than ever before. It means that Alan Greenspan dare not raise interest rates too much or risk sinking the stock market and the economy once again." He concluded: "Bond investors should therefore continue to emphasize the front-end of the yield curve, avoid long-term bonds," which is a pretty strong statement.

McCulley

: He said what he said but in some respect he's talking more about curve structure vs. being an absolute bear on bonds. In that piece he talks that he's not a table-pounding bear on bonds. Inflation risk is higher than what would otherwise be the case and the Fed is reluctant to

tighten aggressively. That basically tells you you should be relatively neutral relative to your benchmarks.

Task

: I thought Gross' comment jibed with your recent comments that "Greenspan wants stocks to outperform bonds in the quarters ahead, and he's willing to underwrite a cyclical increase in inflation to bring about that outcome."

McCulley

: That's correct. We're looking for higher inflation, I just don't think it's enemy number one. For anybody in my chair to say there's such a thing as a benign increase in inflation may sound odd but that's precisely what Mr. Greenspan said. That if you get an increase in inflation simply because the economy firms sufficiently that companies can take back some of the cut-throat discounting, that is not the end of the world. Detroit can't sell cars for less than the cost to make 'em forever.

For more of McCulley's views about inflation, deflation, corporate disclosure and bondholder activism, be sure to tune in for Part 2 of our interview tomorrow.

Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

Aaron L. Task.