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What the Fed's New Long-Run Inflation Outlook Means for Your Portfolio

By Brent Nyitray, CFA – Sep 3, 2020 at 8:30AM

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The risk-reward ratio is sky-high for bonds right now.

The Federal Reserve recently updated its view on monetary policy, and the changes will have broader implications for the economy as well as your investment portfolio. It pays to have a macro view of the economic environment in order to position your portfolio in investments best suited for that set of circumstances.

Here is a quick explanation of what the Fed has changed and what that change means for investors. 

Interest Rates

Image source: Getty Images.

Monetary policy and the role of the Fed

Historically, the Fed has used the Fed Funds rate (the rate at which banks generally lend to each other) as a way to set short-term interest rates. A whole host of other rates, from credit card rates to the prime rate, are directly influenced by changes in the Fed Funds rate.

The Fed has a dual mandate, which goes back to the 1970s, that requires it to control inflation while minimizing unemployment. When the directive was written, during the days of stagflation (sluggish growth and high inflation), "controlling inflation" generally meant decreasing it. 

Inflation and unemployment

The trade-off between inflation and unemployment is referred to as the Phillips curve. Formerly, periods of high inflation were usually associated with strong economic growth, which means low unemployment. Periods of high unemployment were usually associated with recessions and lower inflation.

The late 1970s, which featured high unemployment and high inflation, were a period where the relationship seemed to break down. In the period leading up to the COVID-19 pandemic, the relationship also seemed to have broken down, as we experienced extremely low unemployment and low inflation. These experiences have led academics to believe the Phillips curve changes over time.

During a speech at Jackson Hole, Wyoming, last week, Fed Chairman Jerome Powell explained the changes in the Fed's viewpoint:

Our revised statement says that our policy decision will be informed by our "assessments of the shortfalls of employment from its maximum level" rather than by "deviations from its maximum level" as in our previous statement. This change may appear subtle, but it reflects our view that a robust job market can be sustained without causing an outbreak of inflation.

So what does that statement mean, exactly? It means the Fed is worried more about deflation than inflation.

The practical effect of this changing viewpoint will be that the Fed intends to err on the side of too-low rates. As slack is taken up in the labor market as people return to work, the Fed will resist its urge to raise interest rates. This means rates will be lower for longer.

The recent projection materials from the June Federal Open Markets Committee (FOMC) meeting showed the vast majority of Fed participants see the Fed Funds rate sitting at current levels (0% to 0.25%) through 2022. See the long rows of dots at the bottom of the chart below? Those are interest rate forecasts by the members of the Fed. Essentially every member agrees rates will stay at zero through 2021, and while a few predict an increase in rates in 2022, the vast majority do not. 

Dot Plot from the June 2020 FOMC meeting

Image source: Federal Reserve.

Why the Fed fears deflation

The Fed is trying to avoid the experience of Japan, as alluded to by Jerome Powell: 

But if inflation expectations fall below our 2 percent objective, interest rates would decline in tandem. In turn, we would have less scope to cut interest rates to boost employment during an economic downturn, further diminishing our capacity to stabilize the economy through cutting interest rates. We have seen this adverse dynamic play out in other major economies around the world and have learned that once it sets in, it can be very difficult to overcome. We want to do what we can to prevent such a dynamic from happening here.

Deflation has been a way of life in Japan for a generation, which creates problems in generating economic growth. Deflation encourages people to defer spending (because goods will only get cheaper), which in turn creates a sluggish economy, since consumption is the primary driver of GDP. The Fed is highly concerned about setting up a dynamic of deflationary expectations, because the Fed can't cut rates below zero. This means the Fed's tools become ineffective during deflation, and once deflationary expectations start, it is hard to reverse.

Bonds don't pull their weight these days

So what does this mean for your portfolio? First, it means that stocks will lack much competition from bonds for your investment dollar. Longer-term Treasuries are a "greater fool" game at the moment. Investors buying the 10-year Treasury note at a yield of 0.70% are making a bet that deflation is going to occur and the Fed will continue to support the bond market. Corporate bond yields aren't much better. Take a look at the chart below, which shows the yield on Treasuries, AAA-rated corporate bonds, and high-yield (aka junk) corporate bonds.

US Corporate AAA Effective Yield Chart

US Corporate AAA Effective Yield data by YCharts

To put that chart into perspective, the dividend yield on the S&P 500 SPDR ETF (SPY -1.03%) is 1.85%. Investment-grade debt and Treasuries are priced to provide little upside while having tremendous downside. For a yield investor, the risk-reward of the U.S. bond market is simply awful.

There are stocks with better yields, especially in the REITs, utilities, and financials. And don't forget that if a bond yield is lousy for an investor, that means it is a great yield for an issuer. Companies that have taken advantage of the current environment to refinance older, high-yielding debt will benefit from that for a long time. 

If you own bonds, keep an eye on the exit

Ultimately, the Fed is saying that rates will be at the zero bound for the foreseeable future, which means the next couple of years, or until unemployment gets back to pre-COVID levels and we start seeing an uptick in inflation.

If inflation starts to build, the first sign will be declining bond prices, which will happen before the Fed starts raising rates. Inflation is a bond investor's worst nightmare, and in the early 1980s (when you could get double digits rates in a Treasury), Treasuries were referred to as "certificates of confiscation," which meant the rate of inflation was higher than the yield on the bond. Sure, you were getting interest, but the purchasing power of that money was dramatically lower. Bond investors should be wary at these levels, as the risk-reward characteristics are unappealing right now. 

Brent Nyitray, CFA has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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