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PIMCO’s McCulley: War on Inflation Is ‘Over, Done, Finished’

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PIMCO Chief Economist Paul McCulley, in his first commentary since returning to the bond shop in late May, says the war on inflation “is over.” McCulley adds that “new neutral” federal funds rate is 2%, which means today’s markets are fairly valued.

“The war against inflation initiated by [Federal Reserve Chaiirman Paul] Volcker in 1979 is over, done, finished; we won some 15 years ago,” he explained in his piece “Just Give Me a Framework” on Thursday.

“Accordingly,” he said, “the secular Fed strategy known as ‘opportunistic disinflation’ is dead, along with its companion cyclical implementation strategy of ‘pre-emptive tightening.’ ”

Explaining the implications of his views on CNBC later in the day, McCulley outlined likely Fed action in 2015.

“I think the Fed will tighten next year, but it’s not trying to pre-empt an increase in inflation,” he said on the station. “In fact, the Fed’s told you it won’t hike until after inflation has moved up closer to target. That is a profound paradigm change.”

Though he called recent Fed actions “responsibly irresponsible,” McCulley acknowledges that the policies “have worked.”

“Escape from the Liquidity Trap nears, with the heavy lifting having been done by endogenous delivering of private-sector balance sheets through the alchemy of rising bond and equity prices and valuations, which are fundamentally grounded in structural reduction in the central bank’s neutral real policy rate,” the economist noted in his PIMCO comments.

“We’ve had our cyclical ups and downs but when you look at it on a chart, I think we’ve achieved the promised land of price stability over many cycles,” he shared on CNBC.

Given this stability, bonds and stocks are at “fair valuations,” McCulley added, and are not at “artificial” levels.

While the economist doesn’t see bonds moving higher, stocks could see some positive movement thanks to the stable level of both economic growth and corporate earnings.

As for asset-price inflation, the PIMCO executive says, this is “a good thing!”

“The decisive dynamic behind the Fed’s story of success has, in my view, actually been soaring equity prices and valuations, both publicly traded and private. How so? Equity capital gains are the only asset that does not have a corresponding liability. Thus, soaring equity prices and valuations endogenously heal private sector balance sheets that have too much debt and too little equity.

These capital gains help “de-lever” private-sector balance sheets, “the fundamental cancer of a Liquidity Trap,” he adds.

McCulley notes he sees the American economy as “a going, thriving concern, warts included.”

While, there are “some elements of froth in both [the stock and bond] markets, particularly in specific sectors, “I have no problem with prevailing macro valuations of either asset class,” he said.

Plus, he stressed, valuations could “get richer still, especially for stocks, in the run-up to the day when the FOMC takes an ‘official’ sharp whack to that 4% dot, which I expect will happen before the first policy-rate hike. Ironically, that would probably be a good time to take tactical chips off the equity table, before the Taper Tantrum is reincarnated into the Hike Heebies. But I digress.”

Check out PIMCO’s Gross Cruises Into ‘New Neutral’ on ThinkAdvisor.


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