Viewpoint: The Fed's lost leadership opportunity

Tom Sowanick

24 June 2008

It's as if the U.S. central bank doesn't understand the danger of inflation. Tom Sowanick is CIO of Clearbrook Research, part of Clearbrook Financial, a Princeton, N.J.-based wealth-management service provider.

The Federal Reserve will probably keep rates steady at its 25 June FOMC meeting. This is a missed opportunity for the Fed to regain a senior role in the central-bank community.

How will the Fed explain why it didn't raise interest rates? Other central banks have already started doing so -- or at least they've suggested that rates will be increasing soon. Will the economy be negatively impacted by a 25-basis point increase in rates, or will rising inflation expectations be more destructive to the U.S. consumer and economy?

Inflation must be a very strange concept for people under 50. As a measured by the Consumer Price Index, it peaked in March 1980 at 14.80%. Then it steadily declined through October 2006 to 1.3% before re-accelerating to 4.2%.

Too jaded

Many investors, traders, and economists have no direct experience with rising inflation. Even Fed chairman Ben Bernanke has spent most of his academic life in a disinflationary environment and therefore, may be ill equipped to recognize the danger of letting inflation accelerate.

Protecting assets in an inflationary cycle becomes the paramount issue for investors. Fixed-income assets are the most vulnerable to price erosion because of their fixed coupons and the inability to adjust upwards with inflation.

Small-cap equities, historically, have been a good asset class to own in an inflationary environment. Even in today's difficult equity market, the Russell 2000 Index has lost only 5.04% this year compared with a 10.25% decline for the S&P 500, and a 10.80% drop for the Dow Jones Industrial Average.

If inflation is the primary concern for global consumers and investors, why would the Fed decide not to take a bold stance at this week's FOMC meeting? It is unlikely that the housing market would be affected by a 25-point rate adjustment. Financial institutions have already seen their borrowing cost rise by hundreds of basis points over the past year. Why miss the opportunity to rein in the threat of inflation?

The risk of a renewed broad-based weakening of the dollar will be heightened if the Fed does not begin to lift rates. The Fed knows that the weak dollar has contributed measurably to inflation, not just at home, but also in dollar-pegged countries. The Fed only broadens the ravages of inflation globally by not making this difficult choice.

Investors should consider small-cap stocks as a means of participating and protecting against the threat of inflation. Unfortunately, many investors and policy makers have enjoyed a very long disinflationary cycle and may be too jaded to recognize the need to change course. -FWR

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