How Will the Federal Reserve's New Inflation Target Affect You?

Inflation is Inevitable

I have consistently written about inflation over the past few years and have repeatedly spoken about how I felt that inflation was inevitable and investors needed to be prepared for it. Back in April I predicted that rising government debt would lead to increased inflation over time. Now it seems the Federal Reserve is making higher inflation their policy. It seems the Federal Reserve not only agrees with me, but is actively taking steps to make it happen. What does this mean for the average person?  

Well, because the Federal Reserve is basically the central banker to the world, all other central banks, including the Bank of Canada will likely assume similar inflation targets over the next little while. Because of this, we can expect that interest rates in Canada and the US will be lower for longer. That means your mortgage rate that you pay will be cheaper as well as interest rates on your student loans or other personal lines of credit.

Lower Interest Rates are Good for the Price of Assets

If you're a business owner, this is good for you as well because your business should also be able to borrow at lower rates. Lower interest rates are good for the prices of assets. This includes real estate. Your personal residence will probably appreciate more in a low interest rate environment.

This makes sense if you think about it logically. Lower interest rates means people can afford a larger mortgage. Because they can afford a larger mortgage they can afford to offer more to purchase a home. When everybody can do this, the prices of homes will get bid up. Of course this will vary widely for different cities and in different locations, but overall home prices should do well if interest rates stay low.

Lower interest rates are also a boon for other assets like stocks. Stocks will do well for a number of reasons with lower interest rates. For one thing, businesses will find borrowing money cheaper which should lead to higher profits, all else being equal. Stocks will also do well because they will be relatively more attractive than fixed income investments which will likely be paying lower rates of interest. If a bond or GIC is only paying you 1% interest and you can get a stock that will pay a 3% dividend yield, the stock is much more attractive then if the bond or GIC was also paying 3%.

Furthermore, when an analyst goes to value a stock, they typically use current interest rates as a discount rate to value a business. If the interest rate (discount rate) is lower, that will translate into higher valuations.

Could Lower Interest Rates Lead to Problems?

So stock prices will likely remain higher as long as interest rates stay low. Could lower interest rates lead to problems? Absolutely they could. We are awash in debt all over the world. Low interest rates and easy borrowing can lead to speculative bubbles. There are many potential bubbles right now and any one of them could pop and take down a large part of the financial markets with them.

The pandemic has brought a lot of amateur investors into the markets, and they've often piled into stocks where the fundamentals do not justify their current prices.  This is a recipe for big problems if there is a crash. We are at all time record highs right now, but if there's one thing that 2020 should have taught us by now is that things can turn bad in a real hurry, and if you're not prepared you will lose a lot of money.

Governments Service Higher Debt with Minimal Problem

One thing that is very likely to occur is that inflation will run higher in the future. The Federal Reserve is basically saying that they want higher inflation. This makes sense as it allows governments to service much higher debts without much problem. This is the only real viable way to get out from the mountain of debt these governments are creating right now.

Unfortunately this will be very bad for retirees and pensioners, especially people who are on a fixed income or who are invested in fixed income securities like bonds or GICs. If you're only making 1% on your bond, you need a lot of bonds to be able to live off that income it's paying you. Many people have invested in bonds because they don't want to take on too much risk. Unfortunately for many of these people, they are ignoring the very real inflation risk attached to those bonds which can cause devastating losses over time.

There is also the possibility, no matter how remote it may be, that central banks will lose control over inflation and that could force them to raise rates much higher to ward off an even bigger problem of very high inflation or even hyperinflation. A lot of people who invest in crypto currencies or gold today are convinced that we are heading to this kind of a scenario where the value of a dollar will plummet rapidly. I don't think this is very likely given modern day understanding of monetary policy, but it is nevertheless a risk.

Politicians like Donald Trump have moved the US closer to this scenario with his critics on the independence of the Federal Reserve and also record budget deficits. It is not impossible and therefore needs to be considered as a risk in any investment.

Greater Inequality as a Result

There is also the potential for greater inequality as a result of this policy change as the benefits tend to accrue to the people with assets like stocks and real estate, and the costs more drastically impact those in the lower class who don't own any assets.  We've seen this with central bank policies since 2008 and it is likely to get worse under this policy change, unless there is a drastic change in fiscal policies by governments.

No one can predict exactly how inflation will play out in the future. Central banks have been trying to raise inflation for years without being very successful. It's possible that even with this policy change they could continue to be unsuccessful in raising inflation. I believe that inflation is coming, but I cant predict exactly when.

Difficult to Prepare For

Until it happens it will be difficult for investors to prepare for it. Nevertheless, these large forces in economic policy do have dramatic impacts on our everyday lives, and it is a good idea to prepare for them as best you can.

- Craig White, BA, LL.B., CIM

Craig White is an Investment Advisor at Endeavour Wealth Management with Industrial Alliance Securities Inc, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families. This information has been prepared by Craig White an Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities.

The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.