Insight Line—January 29, 2007

Whether the Federal Reserve Open Market Committee (FOMC) formally adopts inflation targeting as a policy guideline at their January 30-31 meeting or soon thereafter, I am now (after last year arguing to the contrary) convinced it is coming. And my reasoning may surprise you.

Whether the conversation focuses on unfunded liabilities, an aging population, or demographic transition, there is little doubt the subject at hand is the nation’s Social Security System (System). And when the words come from the Chairman of the Federal Reserve Board of Governors (the Board) lawmakers tend to listen more intently.

Why so, you may ask. Because as Chairman of the FOMC, Dr. Bernanke represents a key component to resolving some the questions surrounding the viability and longevity of the System.

In that Chairman Bernanke, himself a Baby Boomer, serves as Board chair until January 2010, I suggest it reasonable to argue that the monetary policies his Board sets in motion, such as inflation targeting, could have profound implications for retiring Boomers and subsequent generations.

My argument, in its most basic form, centers on how allowing inflation levels to exceed that forecasted by the trustees of the System—currently penciled in at 2.8 percent in the intermediate cost analysis— negatively impacts the System’s longevity and viability, while a lower inflation rate produces tangible benefits to both the System and, as noted by Dr. Bernanke in his recent appearance in front of the Senate Budget Committee, the nation as a whole.¹

This is not a new story. After all, Dr. Bernanke’s predecessor Dr. Alan Greenspan worked diligently with members of Congress during his tenure as Chairman of the Board and the FOMC to illuminate the structural pitfalls of the System. Granted, Congress has instituted some minor changes since then: raising the retirement age concurrent with raising or eliminating some of the wage caps. But major changes, such as President Bush’s ill-fated 2005 attempt to radically rethink the System’s decade-old investment dogma, remain some time—if at all—in the future.

However, that doesn’t suggest meaningful change is elusive or, for that matter, wholly dependent upon an act of Congress. And that is where Dr. Bernanke comes in.

As millions of Boomers head toward retirement, few understand the mechanism behind the determination of their monthly Social Security benefit. Essentially, the initial monthly benefit arises from a calculation that considers lifetime earnings adjusted for productivity and inflation and then recalculates the figure as if earned only in the last three years of employment. Once determined, the monthly benefit is never recalculated but is adjusted each year by a Cost of Living Adjustment (COLA) based on the preceding year’s rate of inflation. Needless to say, with more than 70 million Boomers falling under COLA provisions over the coming decade, the sums of money are staggering—even to an economy as large and diverse as ours.

This, as I see it, raises some interesting prospects for someone in Dr. Bernanke’s position. Growth in productivity and wage rates aside, controlling the nation’s rate of inflation is arguably the one System fix that is not dependent upon an act of Congress. If the FOMC successfully executes a policy regime focused on stabilizing or even reducing the annualized rate of change in the Consumer Price Index (CPI), the System’s unfunded liabilities still expand, but at a markedly slower rate. Simply put, lower inflation buys the System more time.

To be sure, the dual mandate from Congress to the Federal Reserve is to promote an economic environment assuring full employment and low inflation. But if history is to be any guide, what policymakers at the FOMC have learned along the way is that the former is far more dependent upon the latter. All of which, to my way of thinking, opens the door for Chairman Bernanke to usher in a new era in monetary policy.

¹ Chairman Ben S. Bernanke, “Long-Term Fiscal Challenges Facing the United States,” Testimony before the Committee of the Budget, U.S. Senate, January 18, 2007, http://www.federalreserve.gov/boarddocs/testimony/2007/20070118/default.htm

This material has been prepared using sources of information generally believed to be reliable. No representation can be made as to its accuracy. The forecasts and opinions in this piece are not necessarily those of Van Kampen, and may not actually come to pass. Information in this report does not pertain to any Van Kampen product and is not a solicitation for any product.