The Fed made an important announcement during the June Federal Open Market Committee meeting about how it will react to inflation going forward and this could help propel the stock market higher.
This is not by the Fed cutting interest rates, although that will likely happen, but rather by changing its inflation target from a 2% ceiling to a 2% average, or what is being coined as a “symmetric target”.
The Feds previous goal of having an inflation rate no higher than 2% led to much of the volatility in the stock market in 2018.
To illustrate, the Core PCE Price Index (which is the Fed’s preferred measure of inflation) has been under 2% annually for 10 straight years.
But last year, as the Core PCE Price Index finally approached the Fed’s 2% inflation target, the Fed hiked rates 4 times to prevent inflation from going over 2%
That, in turn, stifled economic growth, nearly inverted the yield curve, and contributed to a correction in stocks that almost became a bear market.
But, if the inflation target is based on an average, that likely wouldn’t have happened. Why? By using an average, the Fed could have allowed inflation to rise above 2% for several years, while still averaging below 2% inflation, since inflation has been under 2% for the last 10 years.
Practically speaking this will lead to a more dovish Fed than we’ve seen in decades, which means they will be less apt to raise interest rates, which is good for the stock market.
In the 70s and 80s, the Core PCE Price Index was consistently above 2%. In-fact, it rose above 2.5% in the late 1960s and didn’t drop below that level until the mid-1990s, resulting in nearly 30 years of higher inflation.
But in the mid-1990s, the Fed adopted a 2%-ish inflation target, and they’ve been very good at hitting that target ever since, as the Core PCE Price Index hasn’t risen above 2.5% since the mid-1990s.
However, with a new “average” inflation target, that could change.
Over the longer term, we could be investing in an era of higher inflation, something no one in the markets has seen in nearly 30 years. This will likely be a major reversal from the investment strategies that have worked over the last 30 years.
When inflation is higher, it’s good for commodities, hard assets like real estate, and stocks (although it increases volatility), but it’s bad for bonds and cash.
As this new game changing Fed strategy plays out over the next several years we will be watching it closely and keeping you up to speed on any necessary changes to continue to keep our portfolios better protected on the downside with good returns on the upside.
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