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If The Fed Succeeds, We All Lose

Henry Kaufman on the coming changes in Fed policy to target a higher level of core inflation:

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.

If Kaufman is right we get more uncertainty, more volatility and the loss of 1/4 of the dollar’s purchasing power. If you’re buying US stocks right now in anticipation of QE II, in a sense you are betting that Bernanke is right and there are positive benefits to a higher inflation rate. I’m having a tough time with that.