Friday, October 22, 2010

Henry Kaufman's Excellent WSJ Editorial

I haven't thought much of most of Henry Kaufman's Wall Street Journal editorials over the past few years. You can read my posts discussing them under the label 'Henry Kaufman.'

However, I like to believe that I criticize the thoughts, not the person. And Mr. Kaufman outdid himself yesterday with a superb piece entitled Bernanke's Inflation Target Misses the Mark.

He lists six reasons why Bernanke's recent speech indicating that the Fed will accept a 2% inflation target is a serious mistake. The more salient reasons are,

"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.

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."

I find the third and sixth reasons particularly, shall I say, "on target," pun intended? This idea of exempting the major sources of inflation in an inflation index is preposterous. One which CNBC on-air staffer Rick Santelli, as well, routinely criticizes. Then Kaufman sensibly notes that the Fed's own projections are not all that accurate. Not comforting at all, is it, for anyone who lived through the great inflationary period from LBJ to just after Paul Volcker began to wring inflation from the US economy?

Along those lines, Mr. Kaufman next asks reasonable questions. Things seldom turn out perfectly. What about imperfect, vexing combinations of inflation and unemployment,

"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?

Do we trust Helicopter Ben & Co. to manage such situations better than our prior, not-Paul-Volcker Fed Governors?

Kaufman lastly turns to what I think is the curiously missing but incredibly fundamental, important fact in all of the Fed's misguided inflation targeting speak- the debauching of the value of the dollar.

"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."

Pretty stunning figure, isn't it, that 22% purchasing power decline in a decade? The mathematics of compounding get scary at surprisingly low rates.

Consider what global investors must be contemplating as they read Mr. Kaufman's editorial. How comfortable are the Chinese at watching the value of their large dollar-denominated holdings being announced to decline in value by nearly a quarter in the next decade- if they are lucky?

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