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New Federal Reserve inflation policy

2020-09-08, Michael Thompson

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New Federal Reserve inflation policy

This article discusses a recent policy change by the US Federal Reserve. We’ll focus on how this change may impact your investments.

On August 27, Federal Reserve Chairman Jerome Powell announced a change to the inflation target. They will now aim for 2% average inflation rather than 2% inflation. The Fed’s inflation metric, the core personal consumption expenditures price index (PCEPI), has been around 1.5% for years. Hence, it's likely they will allow it to exceed 2% for some time without counteraction. The time period for this average and the methods used to achieve it were not specified, increasing uncertainty in the extent and duration of inflation the Fed will tolerate. If inflation picks up before unemployment is reduced to acceptable levels, this rule will enable the Fed to continue to stimulate the economy with low interest rates and QE type behavior.

What does this mean for investors?

The Fed’s policy will likely lead to lower interest rates for longer time frames. In the recent FOMC meeting, most participants said they anticipate a Fed Funds rate below 0.25% through 2022. This means pitiful short-term treasury returns are likely here for a long time. People in or near retirement, with a large stake in such assets, may have to change course towards riskier investments (and equities) to achieve desired returns. This increase in demand for equities could help bolster prices, despite already high valuations.

In this environment, stocks may continue to trade at historically high valuations. One reason was given above - low bond returns will steer many to hold a lower percentage of bonds and a higher percentage of stocks. Businesses will also be able to borrow at lower rates, increasing their earnings and lowering their chances of failure / bankruptcy.

Easy money policies have helped push up gold prices and led to fears of runaway inflation. The Fed’s new inflation policy may add to these fears for some people. Indeed, the lack of clarity given by the Fed (e.g. will they average over 2 years, 5 years, 10 years, ...) does increase the uncertainty of future inflation. This may increase demand for inflation-protected securities like VTIP. However, most experts do not expect the mass inflation predicted by some gold bugs. Instead, they expect inflation to remain below 2% in the near term, and only gradually increase beyond 2% in the longer term. Even then, they envision inflation numbers below 3.5%. You shouldn't need to buy that wheelbarrow to roll your USD to McDonalds for lunch!

The new Fed policy should also maintain lower short-term interest rates relative to long-term interest rates. Since banks borrow primarily at short-term rates and lend at long-term rates, this can help their bottom line (and their stocks). However, this tailwind may not be enough to cancel out the wave of coronavirus defaults they may endure in the near future.

For more information directly from the Fed see this link.

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