Why is inflation targeting so important for investments?
The Fed’s objectives
One of the main objectives of central banks across the world, including the U.S. Fed, is “price stability.” While moderate inflation is preferable over no inflation or deflation, central banks try to keep inflation in control. The reason for this preference is simple. As inflation increases, the currency’s purchasing power drops. This simply means you’d need more dollars to buy the same product or service you previously bought at a cheaper price. If the prices in a country are rising faster than in the rest of the world, imports become cheaper, resulting in a disadvantage to domestic industry as well as depreciation of the country’s currency.
As a result, central banks and governments try to maintain prices relatively stably and predictably and they direct their monetary policy to achieve this goal. This is evident in the fact that the U.S. Fed has a target of 2% inflation but has no target for future economic growth!
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If inflation in the U.S. rises, investors can benefit from investing in ETFs such as the Vanguard FTSE Emerging Markets ETF (VWO), iShares MSCI Emerging Markets Index Fund (EEM), and iShares MSCI China Index Fund (MCHI). These funds invest in emerging markets such as Brazil, India, China, and Russia (or the BRIC countries). A rise in inflation can eventually hamper bond prices (BND), as the U.S. Fed may increase interest rates to tackle rising inflation. The increase in interest rates discourages consumption, particularly for housing and construction products, affecting theperformance of companies like Home Deport (HD).
The theme of the underlying paper
The underlying paper by Dr. Sheedy that Dr. Bullard discussed tries to build an alternative for the existing approach of inflation targeting.
The paper gives an example of a mortgage payee. Mortgagees borrow for a long period, often spanning 20 to 30 years. While the principal repayments are fixed, they can’t predict their income in the future. The current monetary policy of inflation targeting doesn’t provide a solution to household borrowers’ problem.
Sheedy recommends an alternative approach of targeting income levels to solve household borrowers’ problem. The approach is known as “nominal GDP targeting.”
Bullard’s speech centered on the case for nominal GDP targeting and the monetary policy model Sheedy proposed to counter mortgagees’ problem.
To find out more about why the traditional approach of maintaining prices works with the majority of central bankers, read on to Part 3 of this series.