Inflation’s Impact on Wealth – Part 2

How Does Inflation Targeting Help the Economy?

Before we answer this, let’s looks at the factors driving the Fed to consider this new strategy.

In recent years, 3 economic developments have occurred that drove the FOMC to review their overall strategy:

  • Estimates of the levels associated with full unemployment and target inflation continue to fall both in the U.S. and around the world (aka the neutral rate)
  • Inflation expectations continue to remain below the Fed’s 2% target.
  • Unemployment levels in the U.S. fell to a 50-year low.

inflation's impact on wealth

The lower neutral rate means the short-term interest rates (aka the fed funds rate) that the Fed influences will more likely be closer to or even at zero than previously expected. This gives the Feds little room to cut interest rates in the future if needed.

A great example is European countries that have recently issues negative fed funds rate that their banks use for short-term borrowing. At the current pace the U.S. was going, taking a similar approach would have developed into more of a certainty.

The economy is struggling to reach its target inflation. This gives the Fed insufficient firepower to pull additional levers for slowing down the economy if needed. 50-year low unemployment levels, in theory, should have triggered an inflationary response by the economy. It didn’t.

Lastly, reaching 50-year record low unemployment without inflation is actually good news for the economy since it has widespread benefits. However, the lack of an inflationary response to low unemployment is indicative that reaching the 2% inflation target will take A LOT longer than previously thought. As seen in the graph below, the rate of annual inflation has been below 2% the majority of the time since 2011.

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.

gold / silver prices

Another reason for concern is if inflation is too low and stays that way for an extended period of time, the financial impacts can hamper the types of investments being implemented.

For example and as of this writing, the current 10-year T-Bill rate is 1.73%. Historically speaking, T-Bill rates are at a 50+ year low.

T-Bill Rate

Bonds are also in a similar situation.

Why should we be concerned?

The concern is that the normal “safe havens” for protecting wealth are offering returns that barely keep up with inflation. This forces investors to put the majority of their money in “riskier” asset classes such as stocks in order to obtain the desired yield for promoting portfolio growth.

This also explains why the stock market has been on a record bull run for the last 10+ years and as of now, has no end in sight. It is also driving investors to find alternative asset classes that potentially have even more risk (IF the person has little knowledge in the field) such as P2P lending, venture capital investing, absolute returns, leveraged buyouts, etc. in order to get the desired yield on their investment.

While this has been a record bull run, adjustments to promote future growth are needed.

I wrote an article about alternative asset classes, here. Check it out for more details.

What Can I do to Protect Myself Now?

Well I’m glad you asked! 😊

There are actually a number of things a person can invest in depending on their Investor DNA.

Whatever is decided to do, make sure it follows your investing DNA. Make sure it is something you understand and is intuitive for you. Make sure in falls within your areas of competence. Don’t invest in something just because your neighbor Jim has been successful doing it.

Having said that, the biggest thing to remember is to ensure that a portfolio has a sufficient amount of diversification. I do not mean the type of diversification that most financial advisors preach (i.e. invest in only stocks, bonds, ETF’s, mutual funds, etc.) that simply lines their pockets with more of your hard-earned money with every transaction that is made.

The type of diversification is what I talked about in this article, which deals with finding investments that are negatively correlated or have zero correlation with the stock market.

Negatively correlated investments move in the opposite direction of the stock market. When stocks are up, these types of investments are down and vice versa. Zero correlation means that no matter what direction the stock markets goes in, this type of investment moves independently.

Some great examples of negatively correlated investments are precious metals (i.e. gold, silver, and platinum to name a few), natural resources investing, a side hustle, and real estate. The Yale Endowment Fund, one of the largest and best managed endowment funds in the country, leans heavily on alternative assets and a lot can be learned from watching how they invest and then figuring out what works best for you.

Another thing a person can do is to invest in education. If interested in real estate investing and is one of your strengths, then take real estate courses, research podcasts such as, join a mastermind group, obtain mentors, and learn everything possible before investing any money into it.

The more you learn and the more connections you make, the better the chances of success. Too often people invest in things they do not understand and end up losing their shirt in the process. Take the time to figure what works for you and put yourself in the best possible situation to be successful.


Although interest rate decisions made by the Federal Reserve at first seems like it doesn’t directly affect you, the opposite is true. In fact, it affects everything around you and every financial decision that is made. It affects purchasing decisions, ability to borrow money, and how to invest your hard-earned money.

Prepare yourself now for how the Federal Reserve’s decisions may impact you in the future… you’ll be glad you did! 😊

Live the Life You Love, Want, and Deserve……