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Follow the Fed

Adam M. Grossman  |  October 18, 2020

STOCKS WENT INTO a freefall earlier this year, as I’m sure you recall. But all of a sudden, on March 23, everything changed. The market turned around and, just as quickly as it had dropped, it rebounded. Remarkably, the U.S. stock market is now in positive territory for the year.

What happened on March 23? The situation with the virus didn’t get any better. And it wasn’t Congress or the White House. What happened was that the Federal Reserve issued a statement. In that statement, it announced that it would use its “full range of tools” to help rescue the economy. And, just like that, both the stock and bond markets turned positive and haven’t looked back since.

But for all the Fed’s power, it’s a somewhat inscrutable entity and not well understood. Perhaps that’s why, at the end of August, when the Fed announced revisions to a document some refer to as the Fed’s “constitution,” it didn’t receive nearly as much attention as it deserved.

That document is called the “Statement on Longer-Run Goals and Monetary Policy Strategy.” While that might sound arcane, it’s an important document to understand because of the Fed’s enormous power to move markets.

By way of background, the Fed first created this policy document in 2012 in the wake of the 2008 financial crisis. It describes in straightforward terms how the Fed sees its mandate. Since 2012, the Fed—despite changes in leadership—has reaffirmed this same document each year. But this summer, as the economy grappled with the impact of the coronavirus, Fed officials realized that it was due for an update. These were the key changes:

  • Employment. The Fed’s dual mandate has always included both controlling inflation and maintaining full employment—and it has always stated them in that order. But in the updated document, the Fed says it will now make full employment its first priority.
  • Inflation. In the past, the Fed’s goal has been to achieve an inflation rate of 2%—not higher and not lower. But the updated policy document paints a different picture. The Fed will now target “inflation that averages 2 percent over time.” The key word here is “averages.” The Fed will now allow, and at times even encourage, inflation that runs above 2% to make up for periods during which it’s run below that level.

While these may sound like subtle changes, there are seven key implications for individual investors:

1. Expect low yields. In the Fed’s new framework, it won’t be in a hurry to raise rates even after the economy gets back to normal, which will hopefully be in the next year or two. That’s because, even after a recovery, policymakers will allow time for inflation to reach 2% on average over time. And since we’re currently so far below 2%, it may be another few years or more before that multi-year average is achieved.

In fact, in another document issued last month, the Fed said as much. A survey of Fed officials indicated that they expect short-term interest rates to remain anchored near zero through 2023. The implication: If you’re trying to estimate the returns your portfolio might deliver, it would be prudent to assume a continuation of today’s super-low rates and not bet on anything higher.

2. Plan for higher inflation. It will now be even more important to consider a variety of inflation scenarios in your financial plan. Do you need to worry about inflation topping 10%, like we saw in the 1970s? Probably not. But if the Fed’s target is 2% on average, and we’re currently at 1.4%, you should certainly consider the impact on your financial plan of rates in the 2% to 3% range. While this may not sound like much of a difference, a single percentage point can definitely make a difference when compounded over time.

3. Rethink asset location. In the past, an investment rule of thumb was to hold bonds in retirement accounts, where interest payments would be shielded from taxes. But with rates so low today—and maybe for a while—that’s less important. Even if you’re in a high tax bracket, you should now feel free to hold taxable bonds in taxable accounts if that better suits your needs.

4. Favor the middle. Today, there aren’t meaningful differences among the yields on short-, intermediate- and long-term bonds. But under the Fed’s new framework, it’s possible that more of a gap might open up as the economy improves. That’s because the Fed controls short-term rates and it’s said it’ll be keeping these rates near zero for a good long while. Meanwhile, if investors see the economy improving, they may bid up rates on intermediate- and long-term bonds.

Result? While I’m not ready to recommend long-term bonds, I do think there’s value in holding intermediate-term bonds. Yes, rising rates mean falling prices initially. But there’s a silver lining: Over time, those rising rates translate into higher bond returns.

5. Protect against inflation. Because higher inflation is now more likely, I think it’s even more important to build inflation protection into portfolios. The most effective means to accomplish that, in my opinion, is with inflation-indexed Treasury bonds, formally known as Treasury Inflation-Protected Securities, or TIPS.

6. Stay flexible. When it comes to investment strategy, I’m a big believer in consistency. Those who change strategies too frequently risk whipsaw. But this change in the Fed’s “constitution” serves as a reminder that things can and do change—sometimes in meaningful ways. As you formulate your investment strategy, try to balance consistency with flexibility.

To be sure, historical patterns are important for reference, but there’s no guarantee that the future will mirror the past. In fact, the Fed said as much in the final sentence of its new document. Instead of saying that it would reaffirm the document each year, the new language merely commits to reviewing it. The bottom line: This new policy is itself subject to change.

7. Avoid gold. Despite the potential for higher inflation, I still don’t recommend buying gold as an investment. While gold enjoys a reputation as a hedge against inflation, it hasn’t reliably delivered on that promise. As the historical data show, it’s been more of a hedge against economic uncertainty. But if you want true inflation protection, gold is just a gamble.

Adam M. Grossman’s previous articles include Save and Give FirstDon’t Play Politics and High Anxiety. Adam is the founder of Mayport, a fixed-fee wealth management firm. In his series of free e-books, Adam advocates an evidence-based approach to personal finance. Follow Adam on Twitter @AdamMGrossman.

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Langston Holland
Langston Holland
5 months ago

re: The Fed – you consistently reveal relevant and interesting stuff that is completely off my radar. 🙂

Inflation reminds me of termite infestation that goes unnoticed until significant structural damage occurs. Changing the forecasted inflation rate in my retirement planning software from 2% to 3% knocks 39% off the 2060 present value of my portfolio (my wife’s 100th birthday).

Though not directly indexed to inflation like TIPS, stocks are a claim on real (inflation adjusted) assets and earnings and, in the long run, as companies raise prices for their widgets, their earnings rise as well.

May the magic of holding stock market index funds for the long term never end. 🙂

Adam Grossman
Adam Grossman
5 months ago

Thanks for the comments. Inflation is notoriously difficult to forecast because it’s been all over the place — from the mid-teens to today’s 1-2%. But as you saw in your software, the difference of just one percentage point can make all the difference.

Kevin Knox
Kevin Knox
5 months ago

Thanks for the generally excellent article.

A couple of minor quibbles: iBonds are a far better option than TIPS of any duration. Admittedly the 10K per person annual purchase limit is a hassle, but they should always be mentioned. Short and long-term TIPS now have negative real yields. EE bonds are also great for those with a longer time horizon.

Regarding gold, while it isn’t a good pure inflation hedge, it has been consistently great during times of low real interest rates and, in modest percentages, helps guard against sequence-of-returns risks. Pretty much all of the most successful defensive portfolios I have found include it. And the fact that you’re repeating the old canard about it being purely a poor deflation hedge suggests you might benefit from reading this excellent recent article (to be clear, I am NOT a gold bug and much prefer globally-diversified equities as my primary inflation hedge).

https://portfoliocharts.com/2020/08/21/metal-money-and-the-measurable-value-of-gold/#inflation

Adam Grossman
Adam Grossman
5 months ago
Reply to  Kevin Knox

@:disqus thanks for the feedback and the link.

Regarding gold, the biggest challenge I have with it is that it has no intrinsic value. It doesn’t produce dividends or interest or income of any kind. That means there is no quantitative way to approach valuation for gold. But I appreciate the link.

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