Opinion: New era at Fed targets transparency

An era is ending as Alan Greenspan leaves the Federal Reserve and Ben Bernanke takes the helm.

Does it make a difference? Will there be a continuation of the ratcheting up of interest rates a quarter point at a time, as has been the case 14 times since the battle to conquer inflation began? Or will Bernanke implement his frequently discussed theory of creating economic stability through a “targeted inflation rate”?

And what the heck is a targeted inflation rate and how is it supposed to work? And what, if anything, does it matter in our investment decision process?

Let’s have a go at it.

Here’s one definition of inflation targeting, courtesy of a recent Internet article by Elaine Floyd, writing for an investment industry Web site.

“Inflation targeting is a framework for policy decisions in which the central bank makes an explicit commitment to conduct policy to meet a publicly announced numerical inflation target within a particular time frame.”

What might be the consequences, the potential positives or negatives of this approach?

A primary advantage would be establishing the parameters for inflation, in turn bringing lower volatility to long-term interest rates, which fluctuate with investors’ concerns about future inflation.

Should that happen, the expectation of stable rates would allow businesses, especially those in the financial sector that are interest-sensitive, to plan more precisely and confidently in terms of prices and wages.

The possible downside?

By concentrating on a numerical target, the flexibility that Greenspan appeared to use almost intuitively over his 18 years as chairman would be set aside, taking away some of the monetary policy moves that both he and his predecessor, Paul Volker, used successfully.

Although I have frequently been critical of Greenspan for starting late and staying too long with his interest rate moves, I cannot deny the successes he and Volker had in using all the tools at their disposal to bring down inflation and interest rates from the lofty and economically damaging levels of the early 1980s.

Chairman Bernanke defends inflation targeting by stating that it can work. In a speech Bernanke gave to the National Association of Business Economists in March 2003 (which, unlike those given by Greenspan, is perfectly understandable) he concluded by stating:

“Inflation targeting, at least in its best-practice form, consists of two parts: a policy framework of constrained discretion and a communication strategy that attempts to focus expectations and explain the policy framework to the public. Together, these two elements promote both price stability and well-anchored inflation expectations; the latter in turn facilitates more effective stabilization of output and employment.

Thus, a well-conceived and well-executed strategy of inflation targeting can deliver good results with respect to output and employment as well as inflation.”

He added, “Although communication plays several important roles in inflation targeting, perhaps the most important is focusing and anchoring expectations. Clearly there are limits to what talk can achieve; ultimately, talk must be backed up by action in the form of successful policies.”

While the immediate benefits of adopting a more explicit communication strategy may be modest, “Nevertheless, making the investment now in greater transparency about the central bank’s objectives, plans, and assessments of the economy could pay increasing dividends in the future,” Bernanke said.

Part of the nervousness in the markets, both stock and bond, is the uncertainty of whether the Fed chairman will implement this different method of monetary policy, and if he does, how effective it will be.

Give him time. Perhaps there is another rate hike in the near future – maybe more – and then we will see how well the markets take Mr. Bernanke. Evidence of increased confidence in him will show up first in the bond market, likely in a return to a normal, rather than an inverted, yield curve, then – or even concurrently – in the equity market, with banks, utilities, and home builders stocks responding favorably.

Keep your eyes on those areas. Appreciation in shares of companies such as Bank of America, Citigroup and Pulte may be early signs of the markets’ confidence in our new Federal Reserve chairman.

One big positive that many of us see in his appointment is the belief that Federal Reserve policy and actions will be more transparent and more clearly articulated than in the Greenspan era.

It bears repeating Greenspan’s own words, “I guess I should warn you, if I turn out to be particularly clear, you’ve probably misunderstood what I’ve said.”

Clark Davis is a 37-year investment veteran and CEO of Saint Louis Investment Advisors, a specialized money-management company.[[In-content Ad]]