Inflation’s Impact on Wealth – Part 2

Why Inflation Targeting Helps

Inflation targeting serves several purposes. First, it would allow the Fed leverage in the event of a recession to lower rates in order to promote growth and stave off the recession further.

For the past several years, inflation has been below 2%. The Fed has struggled to meet its target. While the low unemployment is great for the economy, the Fed lacks leverage in case the economy starts to worsen.

One of the main levers is to lower the fed funds rate. Today, the rate is close to zero (0.25% to be exact as of this writing). If the economy worsens, the Fed has little leverage to lower interest rates unless they go into negative territory.

By switching to an average inflation rate, the Fed will take the past into account and set policy with the underlying hope that inflation can be pushed past the 2% target in the near future. A natural consequence with this inflation path is that interest rates would increase from the record low’s we are experiencing today.

Not exorbitantly higher but higher than we have today. This would open up possibilities and levers the Fed can use in the event of an economic downturn occurring.

Average inflation targeting would also enable the FOMC’s ability to enact policy that promotes maximum employment in the event of potential and significant economic disturbances (one of the Fed’s top priorities as mandated by Congress).

Second, it would provide predictability to investors (“anchoring” expectations) whether the Fed may raise or lower rates in coming years. For example, for the past 10 years, the average inflation rate has been below 2%.

Using average inflation targeting, the Fed would take this into account when establishing their future monetary policy and develop policies to increase the inflation rate so that, overall, the 2% target is hit.

Investors would also know this and be able to better predict how to react in the coming years. They would be able to anticipate higher inflation coming and find ways to optimize their portfolio to adjust to the changing times.

Third, using average inflation targeting could contribute to overall price stability. Average inflation targeting has some similarities to price level targeting. With price level targeting, the goal is to affect the rate of change in overall level of prices.

With an average inflation rate target, the Fed aims at a particular rate of change in prices. For example, the Fed might announce that it aims to keep price levels increasing at a 2% annual rate over a specific time period. Monetary policy that is developed would aim to offset periods in which inflation is below 2% with periods in which inflation is above 2% so that, over time, the average annual price rise is 2%.

In an ideal situation, the Fed would aim to achieve an above target inflation rate during abundant times when the lower bound is not a constraint. Then to offset these situations, during less abundant times, the inflation rate would undershoot the target inflation rate so that long-term inflation rate expectations are in line with the target set.

The key to making average inflation target setting work is picking the appropriate period of time over which to calculate the average and the appropriate upper / lower boundaries to operate in. For example, the inflation has been below target for much of the last decade. If the Fed said it would aim for above-average inflation for the remainder of this decade, the risk is that the credibility of the 2% target is compromised.

Businesses, investors, markets, consumers, and even other countries would come to expect that inflation will always be higher than the 2% target. This is an outcome that needs to be avoided.

The upper / lower boundaries are equally important. For example, if the Fed sets the boundaries for a 2% target as 0% – 4% this gives a +/- 2% range to operate in. Letting the economy run too hot or too cold can have devasting consequences on the employment rate, overall investment risk, and bank rates earned on both money loaned out and interest paid on accounts.

This was probably the reason why the Fed has not yet announced the period of time it will use to calculate the average as well as the upper/lower inflation rate boundaries it wants to work under. A lot of thought needs to be put into this because the impacts can be devasting.

Yeah But What About My Investments……

While inflation may not seem like a concern today, the long-term affect of unexpectedly high inflation can be significant. Higher inflation rates impact how much you need to save for retirement, how much of a house down payment is needed, and how much a child’s education will cost.

Higher inflation also affects portfolio holdings especially bonds. With bonds, the fixed payments lose value in high inflation environments. The effect on stocks is also important to note since higher inflation implies that overall interest rates will be higher due to cost of living increases and tend to detract the true value of stocks. Typically in high inflation rate environments, gold and silver become much more valuable. For evidence look to the 70’s of what can happen in high inflation rate environments.

As shown in the chart below from Motley Fool, from 1966 – 1981, gold significantly outperformed stocks by a wide margin. This also coincided with a period of hyperinflation the country was going through.