CREFW-Winter2016

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Winter issue 2016 sponsored by CRE Finance World Winter 2016
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to take a greater share of exports from the U.S. This is why interest
rates are so low. There is not enough global inflation or economic
growth. The U.S. in particular has had a really hard time getting the
inflation rate up to what the Fed defines as, ironically, price stability.
By the way, in my world, price stability means zero inflation, no
inflation, no disinflation, no deflation, it’s just zero. I mean, price
stability is the price of bread is $1, and it stays at $1. The Fed
defines price stability in a strange way. They say price stability
is 2% inflation per year. So by logical extension, they say price
stability is to cut the value of the dollar in half over a 36-year
period. Extend that idea over a human lifetime. The Fed defines
price stability as an 80% decline in the purchasing power of the
dollar over a lifetime. I call that, inflating away the dollar’s value,
but they call it stability.
The Fed is having a really hard time achieving what they call price
stability. Plenty of inflation measures are at zero. These include
“headline” inflation measures, which include energy. If you strip out
energy and or you look at the Personal Consumption Expenditures
index deflator, the core rate the Fed likes to use, these measures
show declines in the rate of inflation — in other words, disinflation —
on a year-over-year basis. The PCE is lower today than it was in
September of 2012 when the Fed began QE3, and it’s lower now
than it was in June of 2014 when they started tapering QE3.
Whether you’re doing QE or tapering QE, the inflation rate has
been lower than — and trending lower. You know, if you look at
what might drive the Fed to do things, obviously, there are many
indicators like interest rates, like the unemployment rate, like the
stock market being high, all those things. But the inflation rate is
not responding like the Fed would want. And with the dollar pretty
much near its all-time high, which was set in March, it’s not likely
they’re going to get that inflation to come back.
It’s funny; there are various estimates of the potential growth rate
of the U.S. economy. The potential of the U.S. economy from the
Congressional Budget Office is something like a 2.5% growth rate.
The Fed’s estimate is much lower than that. A few years ago, the
Fed deemed a 2% growth rate to be below potential. Today the
U.S. is still growing at 2%, but the Fed has ratcheted down their
forecast for potential to a one handle. So by moving the goal posts,
the Fed is able to say: “we’re growing faster than potential.” The
actual growth rate hasn’t changed, it’s just the Fed’s definition of
potential, which, of course, is extraordinarily arbitrary and squishy.
I’d add that methodologies for estimating the potential growth
rates of economies are best taken with a dose of skepticism.
Economists stuff a whole bunch of variables into their computer,
and out comes some number based upon past coefficients and
correlations. But the world is always mutating, so these backward-
looking models don’t work very well.
Things haven’t really changed very much, but the way in which
people choose to perceive them has changed. No doubt the U.S.
economy’s failure to get back to the 3%–4% growth rate we
used to think was long-term achievable is behind the seemingly
orchestrated perception shift.
Stephen Renna: What are your thoughts on the Fed raising
interest rates at this time? I know in the past you’ve been
strongly against for all the reasons you just outlined.
Jeffrey Gundlach: Yes. I think absolutely nothing has changed
except that employment has stayed stable at a decent level now
for a few years. Employment is certainly growing. It’s been about
200,000 per month with volatility, of course But the big red flags
against raising interest rates are credit spreads. The prices of junk
bonds are at multi-year lows today. They’re vastly lower than they
were in September of 2012 when the Fed started QE. The spreads
to Treasuries on investment grade corporate bonds are at levels
where the Fed has never raised interest rates before. Commodity
prices are at a 14-year low. They’re dropping like a stone. You’ve
got oil today at 37 handle. That’s pretty low.
If inflation is part of your thought process, it’s fine for the Fed
people say: “well, there are lags so, inflation might be about to put
in a V bottom, and it could be headed higher, and if we don’t do
something, we’ll be behind on the inflation rate.” I understand that
argument, but it would be important to identify some evidence
that’s underneath that argument. That something has changed
and junk bonds are at the low of the year right now and much
lower than they were anytime during 2014, commodity prices have
crashed over the past year and, of course, that goes hand in glove
with the dollar being up an awful lot.
The inflation-based indicators, the undeniable stress in sectors
of the corporate economy and pricing in the junk bond market, all
of these argue against the raising rates. But the Fed isn’t really
making an argument based on data — regardless of what they say
about data dependency. They simply want to be off zero. The data
haven’t changed since the Fed declined to raise rates in September
and again in October. What’s changed is they’ve decided to try to
talk investors and markets out of overreacting. “Please don’t freak
out, investors. Please don’t have a fit in the financial markets.”
They’ve talked a lot about raising rates, without causing a fit in the
equity market, so they think that the coast is clear to raise rates.
There’s another aspect to the prolonged jawboning about raising
rates. They must worry that the Fed risks becoming the boy who
CREFC Exclusive Interview with Jeffrey Gundlach