Mr. Bernanke's golden opportunity

Posted: Feb 20, 2006 5:05 PM

It may be too early to tell but it could be we have seen a leveling off of the gold price and maybe even a downward break away from its recent high.

If so, we are at a turning point for monetary policy at just the moment a new chairman, Ben Bernanke, takes over at the Federal Reserve Board.

The danger is that the new Fed chairman could squander this golden opportunity to place gold back at the heart of monetary policy. If he fails to watch the price of gold and other price-sensitive indicators as signals of future inflation, and instead relies on faulty demand-side theories of "capacity constraints," "cost-push" inflation and watches backward-looking price-indices, he easily could lead the Fed to make the opposite mistake Alan Greenspan made at the end of his tenure, when he kept interest rates too low for too long. Mark my word, there is more inflation and market turbulence to come as a consequence of the Fed's excessively loose monetary policy during the past several years, and the sooner the Bernanke Fed accepts it can do nothing about this Greenspan inflation and looks to the future, the better.

The price of an ounce of gold peaked at around $572 on Feb. 2 and fell pretty much continuously for next two weeks down to $540 on Feb. 15 - the day the new Fed chairman testified before Congress' House Financial Services Committee.

The price of gold immediately began rising again, and as I write this column the price is back up to $556. Markets could not help but notice that Mr. Bernanke in his testimony did not even mention the price of gold nor did he make reference to other price-sensitive indicators of inflation.

Indeed, Mr. Bernanke seemed to go out of his way to debunk anything resembling a price rule of forward-looking commodity prices with gold as inflation predictors for calibrating the amount of liquidity the Fed injects or withdraws from the economy: "Over the past few decades, policymakers have learned that no single economic or financial indicator - or even a small set of such indicators - can provide reliable guidance for the setting of monetary policy."

Mr. Bernanke, I'm afraid, has grievously misread the historic record, and his outright rejection of a price rule approach to monetary policy was, in my opinion, a most inauspicious beginning to his term as Fed chairman. By spiking the price of gold up, the gold market sent the new chairman a raspberry of its own, a direct consequence, I believe, that the market anticipates further inflation errors to come from the Bernanke Fed.

Unfortunately, Chairman Bernanke was not content to reject a price rule; he tried to mimic Greenspan's famous Oracle-like mumbo jumbo: "Rather (than a price rule), the Federal Reserve, together with all modern central banks, has found that the successful conduct of monetary policy requires painstaking examination of a broad range of economic and financial data, careful consideration of the implications of those data for the likely path of the economy and inflation, and prudent judgment regarding the effects of alternative courses of policy action on prospects for achieving our macroeconomic objectives." Huh? In other words, "The Oracle is dead; long live the Oracle."

Here is the lesson the new Fed chairman must learn immediately if he is not to allow himself to be whipsawed trying to adjust to contemporary inflationary impulses over which he has no control by using backward-looking models and non-rigorous impressions, which will only intensify the turbulence and reinforce problems by untimely actions.

The rule is simple: too much liquidity, inflation; too little liquidity, deflation. The best way the monetary authority can know whether it is injecting the right amount of liquidity is to watch price-sensitive indicators, like the price of gold.

As economist Donald Luskin at Trend Macrolytics pointed out recently, inflation from excessively loose monetary policy during the past couple of years is now baked in the cake, and "there will be a great deal more inflation than anyone expects now - and a lot more market turbulence." Chairman Bernanke must come to terms with the fact that there is little beyond instilling confidence in his future leadership of the Fed that he can do to dampen that turbulence through monetary policy but there is a great deal he can do to amplify it. We must ride it out with an eye to smooth sailing on the other side.

As the inflation wave begins to crest, the Bernanke Fed scrupulously must resist the temptation to clamp down on monetary policy. The central bank can't stem the inflation wave that was generated in the open seas of excessively loose monetary policy a couple of years ago. Instead, the Fed should keep its eye on price-sensitive indicators that convey the inflationary outlook for after the wave hits. Right now, it appears, we could be right on the cusp. If the price of gold has indeed peaked, now is the time to set monetary policy by what Jude Wanniski used to call the "Golden Polaris," the price of gold.