Fed Sees Inflation As Its Top Priority

The unexpected rise in the unemployment rate last week combined with a weak dollar – a combination that could lead to higher inflation and slower growth – continues to further implicate the fear factor among traders/investors, who argue that the central bank, in its eagerness to prove anti-inflationary credentials, may inflict some serious damage on economic growth.

This argument seems mostly based in Bernanke’s latest speech, where he signaled that the Fed now sees fighting inflation, rather than preventing a severe economic slowdown, as its top priority. He added that “The FOMC will strongly resist an erosion of longer-term inflation expectations.”

The Fed Chairman also couple weeks ago finally admitted that the weakness in the greenback was contributing to both higher inflation and elevated inflation expectations. The Dollar’s decline, explained the Fed chairman, could accelerate the rate of inflation inside the United States.

He pledged to strongly resist any decline in public confidence over stable prices. Essentially alluding to the possibility of putting a floor underneath the dollar. However, rhetorics aside, Mr. Bernanke’s latest remarks stand in stark contrast to his recent testimony in front of the House Banking Committee where he stated, in so many words that – the weakness of the dollar only effected Americans who travel abroad.

Now, objectively speaking and without insinuations – in reality, the US does not have a dollar policy other than letting the market determine its value. It is a known fact that we (the US government) do not intervene in the foreign exchange market to support the dollar, and the Federal Reserve’s monetary policy certainly is not directed toward such a goal. That’s why at the very least, the Fed Chairman’s latest strong dollar policy mention should be viewed with a good doze of skepticism.

Interestingly enough, ever since US Treasury Robert Rubin began the tradition in the mid-1990, all his successors continue to insist that a strong dollar is good for America whenever they were asked about the dollar’s value. But, while this seems more responsive than “no comment,” it says little about the course of current and future US government action. In any event, time will tell if the Fed Chair will remain true to his intentions of a dollar policy expansion.

Despite all these factors and concerns of many in relation to economic growth, we would caution against reading too much into dollar headlines or the 0.5% rise in the unemployment rate. In the past 60 years, for example, 85 percent of the time following a 0.3 percent monthly increase in the unemployment rate, stocks have risen in the following 12 months, on average by 15.8 percent (excluding dividends).

The constrained outlook for profit growth does not mean it is time to panic. One major reason – valuations. The S&P 500 currently trades at just 17.5 times trailing earnings. That even takes into account the recent poor financial earnings that may be reversed in the year ahead. Furthermore, Federal Reserve policy is still highly accommodative and productivity is still strong.

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