Paul McCulley, managing director and portfolio manager at Newport Beach-based bond fund operator Pacific Investment Management Co., leads the company’s Cyclical Economic Forums.
During the forums, Pimco’s investment team discusses the outlook for the global economy and the stock and bond markets during the next 12 months.
The following excerpted interview on Pimco’s September Forum was provided by the bond fund management company. For the complete interview, see www.pimco.com. McCulley talks about Fed policy and a slowdown in the housing market.
McCulley joined Pimco in 1999, previously serving as chief economist for the Americas for UBS Warburg. He has a bachelor’s degree from Grinnell College and a master’s of business administration from Columbia University Graduate School of Business.
Pimco is one of the world’s biggest bond fund managers with about $500 billion under management.
How has the economic environment changed in the past six months?
What’s changed is that the level of uncertainty has gone up dramatically. That uncertainty has been turbocharged by Hurricane Katrina, but even before the storm we’ve had two things going on since our March Forum that were raising the level of uncertainty in the economic outlook.
No. 1 is the U.S. housing market and the Federal Reserve’s reaction to the housing market; and No. 2 is that energy prices have gone up dramatically relative to six months ago.
How has Hurricane Katrina affected the economic environment? Has the storm increased the potential for stagflation?
When Hurricane Katrina hit, it upped the ante on the risk of stagflation and the risk that higher energy prices dramatically weaken the consumer’s ability to spend. The most extreme worries have faded in the last couple of weeks as gasoline prices have come back down to pre-storm levels, but they’re still up dramatically on the year. Looking out on the horizon, the biggest issue right now is that natural gas prices and winter heating bills are probably going to be up 30% versus last year. And for a good chunk of the country, that matters even more than the price of filling up the SUV.
With this backdrop of rising uncertainty and the potential for stagflation going into the Cyclical Forum, what did Pimco conclude about the outlook for the next six to 12 months?
As a group, we marked down our growth forecast and marked up our inflation forecast, which is precisely what you would anticipate that we would do in the face of an oil price shock, because that’s what an oil price shock does. For an oil-importing country such as the U.S., it’s a negative for growth and also a negative for inflation. The outlook is stagflationary, but the outlook is for a soft landing of a stagflationary character as opposed to a stagflationary recession, which is what happened after the oil price shocks in 1973 and 1979.
Q: How does the potential for a “stagflationary soft landing” affect the outlook for Fed policy?
With regards to the Fed, the first question is how high they will need to take the Fed Funds rate to get at the property (housing) market. And the second is how long this will take, because when we think in terms of a cyclical outlook, timing is hugely important. Following Hurricane Katrina, I think you have to reduce your trajectory for Fed funds relative to what your trajectory was before this tragedy. As a group, we think that a stagflationary soft landing implies about 4% or so, plus or minus a little bit, as the stopping point in the Fed’s rate hiking campaign. (Editor’s note: the Fed Funds rate is 3.75%.)
Does Pimco believe a 4% Fed Funds rate will be enough to significantly slow the housing market?
For the housing market, our base case scenario is that year-over-year changes in median home prices are going to slow from double-digit increases in the neighborhood of 12% down to mid-single digit increases, which would be a soft landing for housing at the national level. At the same time, we believe there are a number of geographical areas in the real estate market that won’t have a soft landing and could actually see price declines rather than just slower price appreciation.
