To maintain heightened liquidity in the financial system and aid in the economic recovery, the Federal Reserve recently announced that it will modify its long-standing 2% target inflation policy. Every so often a philosophical shift in policy has enduring ramifications and we believe this is one such occasion.
In the past, the Federal Reserve has targeted maintaining an inflation rate of 2%, raising and lowering interest rates as needed to keep the inflation rate as close to that target as possible. As inflation began to approach 2%, the Federal Reserve would begin to raise interest rates to try to prevent inflation from running above 2%. As inflation fell below 2%, rates would be cut to try to bring inflation back up towards 2%. In the new framework, the Federal Reserve announced it will now allow inflation to “run hot”, or run above 2% for an extended period of time provided the average remains close to 2% before beginning to raise rates. The new policy specifically states that it:
“seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.” -Federal Reserve Statement on Longer-Run Goals and Monetary Policy Strategy amended effective August 27, 2020
This shift in policy now means that the Federal Reserve will allow inflation to be +/- 2%, for an average of 2% overtime. Why is this change important? With this change, the Federal Reserve has essentially committed to keeping short-term interest rates as low as possible for as long as possible, possibly for several years at the current projected inflation rates. The Federal Reserve’s preferred inflation measure, the Personal Consumption Expenditure (PCE), has rarely been above 2% over the past 10 years, averaging just 1.60% over that time period. Even going back 20 years, the PCE was only above 2.20% for periods of time from 2006 to 2008, and averaged 1.72% over the full period. Based on the new framework of an average of 2% over time, the Federal Reserve may not have raised rates at all from late 2016 through late 2018, despite the low unemployment rates the economy was experiencing.
In closing, with the Federal Reserve expected to keep rates lower for longer under this new policy, investors in risk assets could continue to see valuation support from low interest rates over an extended period of time. Strategic income investments, such as preferred stocks, along with dividend paying equities could also be attractive options for investors seeking income replacement in this environment, albeit with more potential volatility exposure than from traditional fixed income securities alone. For those seeking additional protection from inflation, a carefully constructed investment in commodities could also be considered.