Is Big Ben Purposely Trying to Tie the Fed's Hands?

Includes: IVV, SPY
by: Don Dion

Potentially big news came from a Ben Bernanke speech at the Cato Institute Wednesday, in which he outlined a far more transparent Federal Reserve. Chief among the soon to be implemented changes are three-year inflation and unemployment forecasts, and it will increase the frequency, producing quarterly forecasts in lieu of semiannual forecasts. Bernanke took office with the goal of increasing transparency, but the change also comes at a crucial time for the Fed.

The U.S. dollar faces increased inflation and selling pressure at the same time the economy is experiencing a credit crisis. The policy prescriptions are contradictory—reduce the money supply or raise rates to shore up the dollar and lower inflation versus increase the money supply or lower rates to help the economy. However, if the Fed releases a 3-year inflation forecast below what investors and traders currently expect, it may be able to shore up the dollar by altering their expectations—assuming they believe the forecast is a stealth target—allowing the Fed to cut rates now without causing a major run on the dollar.

Specifically, Bernanke said, “…clarity about the central bank's policy objectives and strategy may help anchor the public's long-term inflation expectations, which can substantially improve the efficacy of policy and the overall functioning of the economy.”

Bernanke later went on to say, “To illustrate, consider the question of the length of time over which a central bank should aim to restore price stability following an unwanted increase in inflation. A central bank that places weight on both employment and price stability, like the Federal Reserve, would not attempt to disinflate immediately or establish a fixed time frame for the restoration of price stability.”

I believe that he’s saying what matters is the average inflation rate over the next few years, not just the inflation rate in the next three quarters. Maybe the Fed wants to undertake looser monetary policy at the moment, but long-term it has the intent to lower inflation.

The problem with this reasoning, however, is that it’s basically what the Federal Reserve did when it lowered interest rates to 1 percent in 2003. Now, they’re stuck with inflation created by the Greenspan led Fed and a deflating housing bubble that is hammering credit markets. If the Fed cuts now and another economic crisis comes along, the Fed will again be caught between a rock and a hard place, only next time it will have even less ability to act because failing to meet long-range forecasts could damage the credibility of those forecasts.

But perhaps Bernanke wants to tie the Fed’s hands to some degree. Although he has frequently stated that the Fed has a dual mandate of low inflation and full employment, he has yet to say that full employment is an appropriate goal for the Fed, only repeating the line that the Fed has this dual mandate. According to an article in this morning’s Wall Street Journal, Bernanke’s “original goal” was “an explicit inflation target.” Also from the article, he was opposed to an explicit target by other FOMC members “because of concerns it would reduce their flexibility to guide the economy.”

With those restrictions, can Bernanke still get what he wants? Although the Federal Reserve will make forecasts for both unemployment and inflation, the Fed is fully responsible for inflation, whereas unemployment can be a result of many factors, including taxes, regulations, and the global economy. A Fed that misses an unemployment target can live on to fight another day, but a Fed that misses inflation targets—whether explicit or not—will lose most if not all its credibility.

One argument against Bernanke using the opportunity to target inflation is that nothing will change—just because the Fed issues an inflation forecast doesn’t change the fact that the Fed is pursuing a policy of easy money. Since the forecasts will come quarterly and are not explicit targets, the market may consider them of little value or ignore them altogether if they are not met. Also, the Fed’s forecasts will be made by all the members of the FOMC. Unless they agree on a policy direction, the forecast may amount to little more than transparency—an improvement, albeit a small one. Additionally, while Bernanke has not come out in favor of the dual mandate, neither has he opposed it, at least publicly. Although I think this is likely due to political considerations—the current House Financial Services chairman, Barney Frank, supports the full employment mandate, and many members of Congress agree—unless he explicitly makes his opinion known, we can only speculate.

With China’s central bank announcing this morning that the U.S. dollar remains the “main component” of its reserves, a shift in Fed policy could produce a major change in global markets vis-à-vis the U.S. dollar. In the end, though, we will have to wait to see what, if anything, changes once the forecasts are revealed—but we won’t have to wait too long. Next Tuesday, the Fed will release the minutes of the last FOMC meeting and announce its 3-year forecasts for inflation, unemployment, and GDP growth.