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What the next Fed Chairman should do
Inflation isn't a threat at the moment. The top priority is to prevent a recession.
October 25, 2005: 8:05 AM EDT
By Michael Sivy, CNN/Money contributing columnist
A 17-part series on how to achieve maximum returns for the right amount of risk. See all the lessons.

NEW YORK (CNN/Money) - Even before the official nomination came on Monday, the bond market announced what the next Fed Chairman should do -- ensure that a potential economic slowdown doesn't turn into a full-scale recession.

The key to understanding the bond market's message is the level of interest rates. Yields on 10-year Treasury issues are still under 4.5 percent, compared with a median rate since 1926 of 4.2 percent.

Over the same period, inflation has run 2.9 percent. So today's bond yields anticipate inflation that's a bit higher than the historical norm, but still not too serious.

In a bid to keep inflation in check, Federal Reserve chairman Alan Greenspan has raised short-term interest rates 11 times over the past 17 months, to 3.75 percent.

The result is a very narrow spread between short- and long-term Treasury yields, which normally indicates expectations of an economic slowdown. This spread is now less than three-quarters of a percentage point, and anything below 1 point signals the possibility of a slump that could develop into a recession marked by declines in gross domestic product and corporate profits.

President Bush's nomination of Ben Bernanke, chairman of the Council of Economic Advisers and a former Fed Governor, has been well-received in large part because Bernanke appears likely to try to foster economic growth as well as continuing Greenspan's commitment to fighting inflation.

The Washington Establishment is pleased with the nomination since Bernanke has an impeccable academic credentials as well as the right political experience.

But the markets are more concerned with Bernanke's specific views on monetary policy. And so far, at least, the expectations are quite positive.

First, Bernanke is widely perceived as an inflation hawk, just as committed as Greenspan to keeping a lid on the long-term inflation trend.

Second, Bernanke is in favor of making Fed policy more transparent. Over the past few years, Greenspan has allowed the Fed to be slightly more forthcoming about its policy goals, particularly with regard to inflation. And Bernanke is amenable to going even further in that direction, possibly even making inflation goals explicit.

Finally, Bernanke has made statements in the past, including observations in official speeches, that suggest he may be willing to diverge slightly from fighting inflation in the short term, in order to maintain economic growth, or at least to prevent a slowdown from turning into a recession.

Those attitudes are just what the markets want to hear. On Monday, the Dow rose 169 points and yields on 10-year Treasuries ticked up slightly.

Only small portfolio moves needed

What does all this mean for you as an investor? First, despite all the worries, the economy has actually been quite strong over the past two years. Real gross domestic product, in fact, has risen at an above-average rate for nine straight quarters.

From what we know so far, Bernanke seems likely to pursue a policy that would be most likely to continue that growth.

At the same time, there's no reason to think that he will be lax about fighting inflation. Consumer prices are up 4.7 percent over the past 12 months, but only about 2 percent, if food and energy costs are excluded.

Assuming that oil prices stabilize or come down, the long-term inflation trend still doesn't look much higher than the 2 percent target rate that Bernanke favors.

This outlook calls for continuing a steady portfolio strategy. It makes sense to include inflation hedges in your portfolio as a precaution. But since both energy stocks and real estate investment trusts are up a lot over the past year, there aren't a lot of obvious hedges to add. Just hang on to the ones you have.

The greater risk remains an economic slowdown that would lead to earnings disappointments. The best protections there are the obvious ones -- be sure you are as diversified as possible, include stocks with dividends or other income investments in your portfolio, and favor shares with moderate price/earnings ratios below 20.

Sivy on Stocks resources:

Sivy 70: America's best stocks

Guide to Growth


Michael Sivy is an editor-at-large for MONEY magazine. Click here to receive Sivy on Stocks via e-mail every Tuesday.  Top of page

Federal Reserve
Ben Bernanke
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