Bill Gross: Stand By For a Tumultuous 2008 - And Fed Funds at 3%

From PIMCO Managing Director Bill Gross's monthly market commentary for December 2007:

The ultimate destination of Fed Funds is dependent on the state of the domestic economy which, in turn, will be influenced by the direction and level of U.S. housing prices. Chairman Bernanke and his divided band of governors will have to feel their way along this treacherous path with canes in hand—not totally blind, but significantly hampered by a lack of historical context which might point the way to the ideal rate via precedent as opposed to feel. Nonetheless, there are theoretical guidelines which may help to validate or invalidate current assumptions reflected in Fed Funds futures contracts which currently forecast an ultimate floor of 3¼% sometime late in 2008. Traditionalists would point to the "Taylor Rule" which formulaically computes a neutral Fed Funds yield based on divergences of real GDP and inflation from "potential" and "target" levels. Since these levels are somewhat variable and subjective, there is no one number that a computer can spit out, but nonetheless, using reasonable assumptions, neutral Fed Funds levels somewhere in the 4% "+ or –" range are produced. Assuming the Fed would have to drop below neutral to stimulate a faltering economy, the 3¼% Fed Funds futures forecast does not seem unreasonable...

The average real short-term rate using this methodology over the past 8 years has been 1½%. Commonsensically, this 1½% real rate is the neutral rate that has pumped life into our new finance-based economy with its complicated shadow banking system. It is logical to me therefore, to assume that 1½% is the neutral rate required to keep the future Shadow oiled and properly functioning. If so, then 2% core inflation and 1½% real Fed Funds require a drop to at least 3½% just to maintain current momentum. To restart a near recessionary economy we may need to eventually go down to 3% or lower.

Forward-looking bond investors should understand that the shadow banking system has been built on leverage and cheap financing and that to keep it from imploding, a return to Fed Funds levels closer to those of 2003 may be required. While the Fed is not likely to repeat its 1% "deflation insurance" levels of that year, current Fed Funds futures which predict a 3¼% bottom are not likely to be correct either. Standby for a tumultuous 2008 as the market struggles to move from the shadows back into the sunlight of sounder banking and financial management, accompanied by Fed Funds levels at 3% or lower.