Inflation Targeting

Inflation Targeting: What You’re Not Hearing about Ben Bernanke and How It Could Affect Your Portfolio

by Mark Skousen, Chairman, Investment U
Monday, August 28, 2006: Issue #576

How serious is Ben Bernanke about fighting inflation?

Very! “Inflation Targeting,” the policy of the new Fed under Bernanke, will affect your portfolio in many unexpected ways. And I have the inside scoop…

Two years ago, I joined the adjunct faculty at Columbia Business School, where I met Rick Mishkin at the weekly luncheons. You probably have never heard of Professor Mishkin, but Rick is an important figure. He’s a long-time colleague of Bernanke, and together they co-authored a book and several academic articles on the subject of Inflation Targeting.

Mishkin himself is a monetary expert, and is the author of the country’s #1 textbook on monetary economics (including seven pages on Inflation Targeting) called The Economics of Money, Banking and Financial Markets.

He and his buddy, Ben Bernanke, are determined to change Fed policy. Both have built their academic reputation on this powerful tool.

In fact, Mishkin has just taken leave from his position at Columbia Business School and has been appointed a member of the powerful Federal Reserve Board in Washington!

With two members supporting inflation targeting, Bernanke has a good chance of imposing his will on American monetary policy. And if he’s successful, it will impact stocks, gold and other investments. Here’s what to expect…

Bernanke’s Inflation Targeting Challenge: Copy New Zealand

First, here’s some background on Inflation Targeting and the evolution of Fed policy.

Up until the late 1970s, the Fed’s plan was to implement a “low interest rate” environment so that the government could easily finance its deficits.

That changed from 1979 to 1982, when Paul Volcker was called in to fight inflation. He immediately changed the rules in favor of “monetarism,” focusing on controlling the money supply and letting interest rates fluctuate freely. Volcker slammed the monetary breaks, breaking the inflationary psychology, but interest rates skyrocketed to 21% before gradually declining again.

Volcker’s experiment in monetarism ended in the mid-1980s when the relationship between the money supply and the global economy broke down, due to the deregulation of the banking system and the globalization of the economy.

For the next 20 years under the leadership of Alan Greenspan, the Fed switched back to a policy focusing primarily on interest rates – raising them to fight inflation, and cutting them to fight recession. Greenspan was largely successful, even though his Fed changed policies seven times during his 19-year reign (1987-2006).

Bernanke wants to change Fed policy again, and adopt Inflation Targeting, which would mean setting a numeric price goal (around 2% a year) for the public that the board would pledge to meet through its actions.

According to studies by Bernanke and Mishkin, countries that have adopted Inflation Targeting have seen their core inflation rates drop significantly:

New Zealand since 1990
Canada since 1991
The United Kingdom since 1993

New Zealand, in particular, has been successful. Prior to inflation-targeting goals, its inflation rate varied from 10% to 15%. Now the CPI rate in New Zealand is less than 3% a year.

Inflation Targeting Chart

Bernanke wants to achieve the same goal in America. The problem is that inflation is now making a comeback, with oil and commodities rising sharply in an age of war and global uncertainty. The Consumer Price Index (CPI) rate has doubled in the past two years.

Bernanke sees himself as a mini-Paul Volcker, appointed to restore price stability. He wants to prove himself a leader in the fight against inflation. But his goal is going to be very difficult to achieve in an age of high deficits and global warfare against terrorism. The Fed has already created an inverted yield curve, slowed the money supply to a crawl, and caused GDP growth to fall to 2.5%. Clearly, he’s serious about the inflation threat.

What Inflation Targeting Means to Your Investment Portfolio

If Bernanke is successful and inflation is whipped, you will want to reduce your exposure to inflation hedges, such as commodities and gold stocks. Once inflation stabilizes, U.S. stocks should resume a bull market.

But before that happens, there is usually a crisis as asset bubbles collapse (witness the sharp decline in real estate lately). The Fed’s anti-inflation policy could precipitate a recession, or a period of deflation. A large position in cash might be warranted during this period of uncertainty.

Remember the 1920s, when Irving Fisher – the premier monetary expert of his time – recommended Inflation Targeting as the best way to stabilize the economy. Prices were relatively stable in the 1920s, and Fisher thought everything was fine in the “New Era” economy.

As a result, he failed to anticipate the growing economic storm. He was wiped out by the 1929 crash and the 1930-33 depression.

I don’t see a catastrophe as bad as the Great Depression, but a crisis could develop, and we must be prepared if Inflation Targeting backfires.

Good trading,

Mark

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