Earlier this year, as I’m sure you recall, the stock market went into freefall. But all of a sudden, on March 23rd, everything changed. The market turned around, and just as quickly as it had dropped, it started to rebound. Remarkably, the U.S. stock market is now in positive territory for the year.
What happened on March 23rd? 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, merely by announcing their intentions, both the stock and bond markets turned positive and haven’t looked back since.
But for all the Fed’s power, it is a somewhat inscrutable entity and not well understood. 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. And while that might sound arcane, it’s important to understand. It’s important because of the Fed’s enormous power to move markets, as witnessed in March and many times before. Below is a summary of the changes the Fed made to this document, and then I’ll discuss what those changes mean for investors.
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 (a) controlling inflation and (b) 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 very 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% in order to make up for periods in which it has run below that level.
While these may sound like subtle changes, there are several implications for individual investors:
Returns expectations: In the Fed’s new framework, it won’t be in a hurry to raise rates even after the economy gets back to normal (hopefully) 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.
Financial planning: 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 around 1.5%, then you should certainly consider the impact of rates in the 2-3% range on your plan. While this may not sound like much of a difference, single percentage points definitely can make a difference when compounded over time.
Portfolio construction: 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.
The yield curve: Today, there aren’t meaningful differences among the returns 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 they’ve said they’ll be keeping these rates near zero for a good long while. But if investors see the economy improving, they may bid up rates on intermediate- and long-term bonds. The implication: While I’m not ready to recommend long-term bonds, I do think there’s value in holding intermediate-term bonds. Yes, rising rates translate into falling prices initially, but over time, rising rates translate into higher returns on bonds.
Protecting 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 Treasury Inflation Protected Securities (commonly known as TIPS).
A changing world: 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 very 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. So this new policy is itself subject to change.
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 has not reliably delivered on that promise. As the historical data shows, it’s been more of a hedge against economic uncertainty. But if you want true inflation protection, gold is just a gamble.