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Fed's Exit Strategy in the Context of Inflation Bias


The Fed will risk price stability to insure growth, which will present dangers and opportunities for investors.

In my previous article, I laid out a fundamental dilemma faced by the Fed. As the economic recovery progresses and the Fed contemplates monetary policy tightening ("normalization" in fed-speak), from the point of view of the scrutiny provided by financial markets, they are essentially "dammed if the do, and dammed if they don't." Consequently, it's virtually unavoidable that in designing its "exit strategy" as well as the accompanying communications strategy, the Fed will have to choose "the lesser of two evils."

Although the Fed will attempt to employ Orwellian doublespeak to placate or otherwise confuse both the "dove" and the "hawk" camps simultaneously, the fact is that the Fed's bias will ultimately become evident in objective measures of the degree of monetary ease signaled by indicators such as the Taylor Rule and/or measures of money growth.

For reasons alluded to in the previous article and expanded upon in this one, in the current context, which is in many ways similar to that of the 2002-2005 period, due to the Fed's congressionally mandated charter and the ideological biases displayed by Fed Chairman Ben Bernanke and most Fed officials, it is virtually guaranteed that the Fed will evince what economists refer to as an "inflation bias."

It's important that investors understand that in the short term, an inflation bias is tantamount to a growth bias.

The Phenomenon of Inflation Bias

In economics literature, a systemic "inflation bias" in the behavior of monetary authorities has been hypothesized to emerge from several possible contexts.

1. Political pressure. Kydland and Prescott (1977) and Barro and Gordon (1983) are credited with the traditional formulation of inflation bias. Factors such as the pressure to achieve low unemployment levels (even below the natural rate) and electoral cycles have been cited.

2. Ideological fashion. Not often discussed in the literature are the ebb and flow of intellectual fashions. In this context, it seems quite clear that there's currently an overwhelming consensus within the economics profession, dominated by monetarist and neo-Keynesian theories and narratives, that contains an inflation bias at its core. Specifically, a central tenet of monetarist and neo-Keynesian theory is that modest inflation is preferable to modest deflation.

3. Cognitive dissonance. Cukierman (2002) is credited with initiating a line of thought called the "new inflation bias." The theory essentially says that asymmetries and irresolvable uncertainties with regards to the future tend to create a systemic "conservative" bias among central bankers fearing the consequences of a severe recession. In this regard, the phenomenon affecting central bankers described by Cukierman is just a specific manifestation of the more general phenomenon of risk aversion, evident in myriad areas of human behavior

Whether or not one believes that "inflation bias" is a general and systemic phenomenon, it's virtually indisputable that it is present in the Bernanke Fed. From their writings and public statements it seems quite clear that Bernanke as well as most other Fed committee members fear "tightening too much too soon," far more than they fear "keeping interest rates too low for too long."
No positions in stocks mentioned.
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