BERNANKE´S INFLATION TARGET MISSES THE MARK / THE WALL STREET JOURNAL OP EDITORIAL ( VERY HIGHLY RECOMMENDED READING )

OPINION

OCTOBER 20, 2010.

Bernanke's Inflation Target Misses the Mark


The more latitude the Fed has to try to spur economic growth, the more economic uncertainty there will be.

By HENRY KAUFMAN

In an important speech last week in Boston, Federal Reserve Chairman Ben Bernanke proposed that the central bank pursue a monetary policy that would encourage some growth in the rate of inflation, presumably a 2% annual rate of increase in the core rate of the personal consumption price index (excluding the cost of food and energy). Such a tactic, according to Mr. Bernanke, would be in keeping with the Fed's dual mandate, as stated in the Full Employment Act of 1946, to pursue policies that will achieve maximum employment and price stability.


The dual mandate has not been in the forefront of monetary policy discussions for some time. Now Mr. Bernanke has resurrected it. The mandate requires making judgments about trade-offs between economic growth and inflation. In recent decades, American presidents have allowed the Fed considerable leeway in the formulation of monetary policy. There was more or less an understanding that Fed policies would lead to stability, an environment in which inflation would not be a key consideration in business and financial decisions.


What are the arguments put forth by Mr. Bernanke, and what are their shortcomings?


First, the chairman states that there is no need to worry about a return of inflation soon. Costs are being constrained by high unemployment and excess production capacity. This is true enough. He admits, however, that some of our high unemployment is due to structural developments such as barriers to labor mobility that cannot be cured by monetary policy alone.


Second, he states that inflationary expectations are low, and that by itself would support a much more aggressive stance by the Fed. However, the chairman makes no assessment of how inflationary expectations will be affected when the Fed pursues policies that will raise the rate of inflation.


Third, the Fed will use as an inflation target the core index for personal expenditure, excluding the cost of energy and food. The exclusion of food and energy from the inflationary indices dates back to the 1970s, when Arthur Burns was Fed chairman. Burns did this to minimize perception of the outbreak of inflation at that time.


But even if food and energy may be more volatile than other cost indices, it is dangerous to exclude them. Food and energy prices clearly affect household spending. Moreover, by excluding energy prices—especially oil—the Fed's monetary policy serves to support the pricing practices of the international oil cartel by supplying sufficient bank reserves to justify those prices.


Fourth, the chairman tries to support his recommendation by stating that "an inflation rate modestly above zero is shared by virtually all central banks around the world." That advocacy should hardly be considered a powerful endorsement, in view of the poor performance of many central banks abroad.


Fifth, through the use of inflation targeting, Mr. Bernanke believes that the Fed will have greater latitude, as he said last week in Boston, "to reduce the target federal-funds rate when needed to stimulate increased economic activity and employment." However, there is no evidence to suggest that under dire future economic circumstances the funds rate would not have to fall to near zero, where it is now.


Sixth, the Fed's inflation-targeting process is to be hinged to the Summary of Economic Projections, which the Fed now publishes four times a year. These projections span three years ahead and include projections for the rate of economic growth, unemployment and inflation. The chairman made no comment about the accuracy of these projections since their initiation three years ago. The fact is that they have been off the mark.


Now that an inflationary bias will be introduced in monetary policy, market and economic uncertainty will heighten. How long will the Fed allow inflation to breach the 2% level before it pulls back on the monetary reins? Will the breach be allowed for one or two quarters or longer? Suppose the unemployment rate falls to 8.5% but the inflation rate reaches 3%. What then?


At a minimum, the new Fed approach will increase financial markets' volatility. For the near term, a new quantitative easing action as is now generally anticipated will most likely require much larger purchases of longer-term government bonds as the market evaluates the longer-term negative implications of the Fed's new monetary approach.


More importantly, if a 2% annual increase in inflation becomes an acceptable target, Americans will be forced to accept a substantial depreciation in the purchasing power of their currency. A 2% annual depreciation equals a compounded loss of 22% over 10 years, and the loss would total 34% if the inflation rate averages 3% annually. That's a target we can afford to miss.


Mr. Kaufman is president of Henry Kaufman & Company Inc. and author of "The Road to Financial Reformation: Warnings, Consequences, Reforms" (Wiley, 2009).

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