A recent Yahoo Finance poll asked readers what presently poses a greater danger to the economy, inflation or recession. Though high inflation has traditionally helped bring on recessions, the Bernanke Federal Reserve has redefined inflation as the result of too much growth relative to the U.S. economy’s labor and production capacity. In its press release last week, the Federal Open Market Committee (FOMC) cited “the cumulative effects of monetary policy and other factors restraining aggregate demand” as evidence that inflation is contained.

While U.S. businesses access worldwide capacity and labor pools, the Fed (at least publicly) persists in viewing the U.S. economy as a closed one — one with static amounts of labor and capacity that do not change in response to shifts in the economic landscape. Rather than letting market prices such as gold guide management of the dollar, today’s Fed seemingly follows an “economy rule,” whereby it will raise its target interest rate when backward-looking government indicators of growth suggest economic strength, and cut rates when those same indicators suggest weakness.

At a time when the truth of free markets triumphs around the world, one of the world’s freest economies has a monetary authority that engages in central planning of the worst kind. Market signals and prices can guide the actions of individuals and businesses. But the Bernanke Fed distorts these necessary signals when it assumes that the eleven “wise men” at the FOMC can somehow use the interest-rate mechanism to guide the economy in between the Scylla of recession and the Charybdis of “inflationary growth.” (The latter is a textbook definition of oxymoron.)

From an investment perspective, those eager to access dollars and dollar-denominated assets must do so with the ever-present risk of a Fed that will overshoot or undershoot, and in the process send the economy into recession. This alone is arguably a big factor weighing on dollar demand, and helps explain the dollar’s freefall versus gold despite 17 rate hikes since June 2004.

Worse, the Fed’s unhealthy obsession with government indicators of economic growth has led to a higher level of short-term interest-rate uncertainty, as evidenced by gyrations in the fed funds futures market. Indeed, when the Commerce Department announced on August 1 that prices in June were 2.4 percent higher than a year earlier, fed funds futures priced in a greater likelihood that the Fed would raise its target rate to 5.5 percent on August 8. Three days later the Labor Department announced weak employment numbers, and the market odds of a rate hike fell all the way to 20 percent. As is now known, the Fed chose to pause last week, but when retail sales rose a stronger-than-expected 1.4 percent last Friday, the market odds of a hike to 5.5 percent on September 20 rose from 27 percent to 38 percent.

While the value of the dollar versus gold strengthened last week, it might be overly optimistic to assume that the trend will continue. In targeting economic growth as the main source of inflation, the Fed is implicitly targeting the dollar. This alone will drive the marginal investor away from dollar-denominated assets. Combined with the interest-rate-uncertainty that results from the Fed’s economy rule, it shouldn’t be a surprise that the dollar remains in inflationary territory.

In defense of Ben Bernanke, it was his predecessor, Alan Greenspan, who resurrected the Phillips curve in the late 1990s with frequent commentary suggesting the “economy could overheat” if “demand growth persists or strengthens.” Stocks have been flat since then in nominal terms, and in real terms they are even weaker.

The Bush administration should take note: Fed policy aimed at economic growth rather than dollar-price stability is anathema to strong stock market performance. Nearly six years in office, this is now the Bush stock market. While the Fed is supposed to be immune from political pressure, the administration might be wise to quietly demand a change in the bank’s operating procedures.

– John Tamny is a writer in Washington, D.C. He can be reached at [email protected].