The Failure of Inflation Targeting
Inflation targeting is yet to be formally adopted by the Federal Reserve (Fed), but recent market and Fed actions already prove that it is a failure. At the whim of trouble in the markets, Fed Chairman Bernanke has made it clear that he is inclined to flood the markets with liquidity at any cost; he said: "We stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks."
Contrast that with John-Claude Trichet's comments: the head of the European Central Bank (ECB) recently said that during times of financial turmoil, it is imperative that inflationary expectations remain firmly anchored. The Fed's increasing isolation is also apparent from recent comments by Mervyn King, the governor of the Bank of England who said that investors had been mispricing risk for far too long and that "the repricing of that risk ... is not a process that we should try to reverse."
Let me be clear: we have no problem with a central bank to switch into emergency mode per se. But the way the Fed has wobbled into emergency mode, claiming to be vigilant on inflation while debasing the dollar in the process smells of hypocrisy. A central bank's role is to keep the financial system running, not to run the financial system. Ben Bernanke has very clear views on how the financial system ought to be running. In February 2004, when he was freshly sworn in as a Fed Governor, Ben Bernanke published a report called "The Great Moderation." In this report, he praised how monetary policy has contributed to a reduction in volatility of output and inflation since the mid 1980s. At first sight, it seems difficult to argue with such analysis; this work may have contributed to his appointment as President Bush's Chief Economic Advisor, and subsequently to his current role as Chairman of the Federal Reserve.
While we do not deny that low volatility has positive implications, where there is sunshine, there is shadow: in our assessment, the seeds of the current crisis have been planted in the process. Even if you are not an economics Ph.D., you may recall the saying "if there is one thing the market does not like, it is uncertainty." The less uncertain the world is, the more daring speculators become. Homeowners believing their jobs are secure, or their wages will rise, are more likely to take out a high mortgage. Any speculator is willing to take out more leverage when the future seems certain. Financial institutions have become increasingly "sophisticated" over the past decade and introduced widely acclaimed Value At Risk (VaR) models; these models assess the risk of loss given different scenarios. Put simply, the less volatility, the less uncertainty there is, the more capital may be put at risk. In recent days, there has been talk that banks may require over hundred billion in additional capital should mortgage insurers be downgraded. That's because the banks' models suggest that less capital is required for assets classified as safe; however, if someone spoils the party and says the world is a risky place, banks suddenly have a greater portion of their capital at risk, requiring them to either sell off risky assets on their balance sheets, or to raise more capital.
This academic sounding concept has major implications for a credit driven world: every speculator, homeowner, bank, private equity firm, hedge fund, bank, is borrowing more money in an environment of low volatility. The process of borrowing money increases money supply. Up until a year ago, this money went into all asset classes, from stocks to bonds to commodities to real estate. The alarm bells should have gone off at the Fed long ago because just about all asset classes were rising simultaneously. This can only happen when a bubble is in the making. Usually, investors invest in either stocks or bonds; commodities don't usually move in tandem with the stock market, but have low correlations.
Rather than being alarmed at the growth of money supply, the Federal Reserve patted itself on the back for having reached an era of lower volatility. In March 2006, the Fed ceased publishing M3, a broad measure of money supply because "M3 does not appear to convey any additional information about economic activity ... and has not played a role in the monetary policy process for many years." We even agree with the Fed that M3 is an outdated measure of money supply. But its shortcoming is that it is too narrow a measure; rather than turning its back to the study of money supply, the Fed should have intensified its efforts, trying to understand how modern financial instruments influence money supply.
Instead, the Fed is increasingly focused on inflation. The problem is that inflation is a lagging indicator. Not only that, the government has changed the definition of inflation so many times that it has become rather meaningless. Incidentally, inflation used to be monetary inflation, pure and simple; nowadays, it is whatever variation of the consumer price index seems appropriate to justify a policy decision. Take the widely cited focus on "core" inflation that excludes food and energy. Such exclusions may have originally been justified: food and energy prices were notoriously volatile and may make monetary decision making more difficult. But when you have food and energy prices elevated for years, when you burn food to create energy, that justification no longer exists, and neglecting it in monetary decision making is, to put it mildly, inappropriate.
In its efforts to keep volatility in inflation and output low, the Federal Reserve has been tempted to sugarcoat structural problems in the economy. The real world, of course, is not risk-free, and volatility has come back with a vengeance. In the process of de-leveraging, speculators withdraw money from all assets. And because the U.S. (consumers and the government) has been the world leader in borrowing, the traditional safe haven, the U.S. dollar, is also under pressure.
Rather than allowing volatility to return to the markets, the Federal Reserve is fighting market forces, incidentally by increasing money supply. But the market is more powerful than the Fed. Also, as the Fed has lost a lot of credibility in recent months, any policy action is far more expensive than in the past: the much-touted increased transparency was aimed at managing the yield curve (the relationship between long-term and short-term interest rates) through words rather than policy actions. Now, the Fed had to have an intra-meeting rate cut of 0.75% to try to achieve its objective.
Just as the pitfalls of the Value At Risk models are haunting us now, just as the Federal Reserve's attempts to reduce market volatility are backfiring, the entire industry focuses too much on "normalcy." The Fed's models work great during normal times; during times, we might argue, we don't need the Fed. And during times of turbulence, the best the Fed is struggling to match expectations set in the bond futures markets; again, one has to wonder why we have a Federal Reserve in the first place, if all it can do is create inflation.
During the Fed's emergency rate cut, only William Poole, governor of the Federal Reserve Bank of St. Louis, voted against the cut; while Mr. Poole would also be hesitant to tighten monetary policy merely because of an increase of money supply without signs of increased pressure on prices, at least he is consistent. Not only that, it is good to have a healthy respect for market forces demanding an increase in money supply, as there may well be reasons why an increase in money supply is due to sustainable increases in economic activity.
In our humble opinion, Inflation Targeting should be dead. Monetary policy ought to focus on money supply, to dampen monetary bubbles as they develop. And if there are extended "normal" periods where the Fed's role is to do nothing, then that's not a reason to find a new target, but to stay on the sidelines. The current thinking at the Fed is that bubbles must not be prevented from happening, as it would amount to interfering with asset prices; with due respect, all monetary policy interferes with asset prices, and the most recent emergency rate cut does so more blatantly than orderly policy would have done.
We manage the Merk Hard Currency Fund, a fund that seeks to profit from a potential decline in the dollar. To learn more about the Fund, or to subscribe to our free newsletter, please visit www.merkfund.com.