Morgan Stanley
  • Wealth Management
  • Sep 8, 2020

Why the Fed’s New Inflation Policy Is a Big Deal for Investors

Investors shrugged when the U.S. central bank recently changed its inflation-targeting stance, but they should pay attention to how it could affect markets going forward.

In late August at their annual symposium, the Federal Reserve announced a new framework for managing inflation known as “average inflation targeting.” Although the market has all but ignored this policy shift, I consider it to be an important historic event.

Essentially, the Fed now believes that if inflation averages below 2% for long periods, as it has for the past 10 years, then it could allow inflation to run well above 2% for long periods to achieve the traditional 2% target, on average. This sounds like a plan not only to embrace inflationary flare-ups, but potentially to stoke them. 

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It also appears that the Fed has now officially dispensed with the Phillips Curve—an economic theory that lower levels of unemployment contribute to higher wages and, in turn, higher inflation. In other words, the Fed is signaling that it may no longer raise interest rates to curb rising prices or tight labor markets, suggesting a perpetual hold on current near-zero rates. That could mean the end of policies first put in place by Fed Chair Paul Volcker 40 years ago, which resulted in a decades-long bull market in Treasurys.

Yet global markets seemed to interpret the move as just a tweak to the “lower for longer” interest-rate narrative that has fueled market momentum. I worry that such a simple interpretation could expose investors to unexpected risks.

Inflation Pressure Builds

We will likely see measures of inflation increase in the coming year due to the massive amounts of fiscal and monetary stimulus added this year to combat the effects of the pandemic. Already, 10-year inflation breakevens, a measure of inflation expectations, have risen to 1.8% from a March low of 0.5%. Longer term trends also point to higher inflation ahead. We describe those trends as “the four Ds” (demographics, deglobalization, debt and deficits, and dollar debasement). 

So far, we’ve begun to see these shifts in the trade-weighted dollar, which has weakened. A weaker dollar also contributes to inflation, since it makes imports more expensive for U.S. consumers. When stock and bond markets eventually respond to rising inflation expectations, which we expect over the intermediate term, it may not be pretty.

Market Impact

Inflation typically leads to higher long-term interest rates. That should pressure Treasury prices, and lift yields, which have an inverse dynamic. Higher long-term rates would also likely lead to lower valuations for many of the high-priced growth stocks that have led the market in recent years. That’s because stocks are often valued based on their expected returns above a Treasury yield.

If this picture plays out as we expect, investors could see both stocks and bonds fall in price at the same time. That means that traditional portfolio diversification strategies may not work as expected in the next downturn.

I suggest that investors add inflation protection to their portfolios through investments such commodities, real estate and Treasury Inflation-Protected Securities (known as TIPS). Meantime, consider reducing reliance on familiar sources of diversification, such as long duration Treasurys. 

This article is based on Sep 8, 2020, "Unappreciated Significance of Fed Policy Shift." Ask your Financial Advisor for a copy or find an advisor. Listen to the audiocast based on this report.