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Margaret Moran
Margaret Moran
Articles (448) 

Friend or Foe: Could the Fed's Push for Higher Inflation Backfire?

A higher target rate can be good for the economy, but there are some things investors need to keep an eye on

January 11, 2021

On Sept. 16, the U.S. Federal Reserve released its monetary policy statements following September's Federal Open Market Committee meeting. As investors and analysts alike expected, the central bank decided to keep the base interest rate at 0% to 0.25% to stimulate the weak economy and make borrowing cheaper.

Additionally, due to continued low economic activity and unemployment compared to recent years, the committee now aims for increased inflation, perhaps even surpassing 2%, which it hopes will result in a "longer run" average of 2%.

Inflation has typically averaged below 2% in recent times. Between 2010 and 2020, U.S. dollar inflation averaged below 2% in six years - 2010, 2013, 2014, 2015, 2016 and 2019. As a result, the FOMC is aiming for conditions in which inflation will "moderately exceed 2 percent for some time" before reassessing the policy, indicating that inflation will likely exceed 2% in at least six years over the next decade in the FOMC's ideal scenario.

While some analysts concur that the extra leeway for higher inflation is exactly what the market needs, others forecast that things could quickly spiral out of control if certain conditions are met. As long as the economic recession from the Covid-19 crisis continues, any increases in inflation due to the record-low interest rates and lax monetary policy will likely be tamped down by things like higher unemployment. On the other hand, if the economic situation were to take a sudden turn for the better, a strong economy would meet extreme recessionary monetary policy, which could result in an unpleasant surprise for investors.

The good vs. the bad

Targeting an inflation rate that is moderately higher than 2% could help the economy in some ways. Economists disagree on whether it can have any real effect on pulling an economy out of a recession, but inflation is typically better than deflation (the exception being when inflation spirals out of control). One positive point is that it allows greater opportunity for wages to be increased. It also makes it easier for the Fed to implement easy monetary policy.

A healthy economy will naturally have some inflation, though the Fed has typically preferred to keep the "breakeven" rate for 10-year inflation expectations at 1.4% rather than its new goal of more than 2%.

On the downside, inflation decreases the value of all existing funds denominated in that currency, including money in savings accounts and investments. A strong enough spike in inflation decreases the value of investment dollars, as investments that return less than the inflation rate will bring in a loss even if they grow in nominal value. Additionally, the real value of wages decreases, so if wages are not adjusted appropriately, which is a real danger in a recession due to higher unemployment, it could result in less money circulating through the economy.

Additionally, regardless of whether or not they consider inflation a good solution to recessionary conditions, most economists concur that it is unsustainable. Targeting higher inflation in the long-term results in more dramatic boom and bust economic cycles. For example, the U.K. targeted higher inflation in the 1980s, but when the government was inevitably forced to take steps to counter inflation, it resulted in the recession of 1990 to 1992. The alternative would have been to allow hyperinflation, which is what destroyed the economies of Zimbabwe and Venezuela.

How inflation could get out of hand

Of course, the 2% to 4% inflation rates that the Fed is attempting to hit in 2021 are nowhere near the 50% required to hit hyperinflation, but the problem is that inflation tends to grow exponentially, which is why it is important to keep to keep it under control.

While inflation can occur naturally when the economy improves, that's certainly not the whole picture. It can occur any time the demand for products and services outpaces the supply. This can be when the economy is booming and there is a higher demand for non-essential goods, or when something occurs to hurt the supply chain, such as the increasing cost of materials.

The pressures that the Covid-19 pandemic put on the supply side of things were initially mirrored on the demand side as well. Higher unemployment also translates to a surplus of labor, which will help counteract inflation when the economy recovers and demand increases again, but this many not be enough to counteract the "pent-up demand" phenomenon. While the pandemic did result in a demand shock, a significant portion of the reduction in demand was for things that people could just as easily buy once the economy improves, and many retailers are already banking on the backlogged demand for their goods and services to come to the forefront once the vaccine rolls out and the Covid-19 infection rate drops.

On the other hand, making it too easy for cash-burning, debt-ridden companies to take on even more debt at record-low rates encourages inefficient operation. In a healthy market, businesses that are inefficient are allowed to fail so that better competitors can take their place, which increases the value of the market as a whole. Letting too many "zombie companies," or companies that are losing money rather than earning it, continue to operate via bailouts and low-interest debt offerings results in a decrease in real value in the long run.

Individually, lower interest rates, a higher inflation target and pent-up demand would not pose a significant danger of causing a spike in inflation. However, when put together, there is a high degree of unpredictability on exactly how powerful this combination will be.

Inflating a bubble and hoping it pops

For investors, there is another important aspect of this situation that should not be ignored – the combination of an economic recession and a stock market bubble.

One of the key arguments of those who say that the current stock market is not overvalued is that the Fed will not allow stock prices to fall. Another argument is that the mega-cap tech stocks that account for the lion's share of higher valuations could not possibly see their prices drop, since their business prospects are too good.

However, these arguments don't hold water if the Fed turns out not to be all-powerful. Peter Boockvar, chief investment officer at Bleakley Advisory Group, recently stated:

"They're purposely inflating a bubble and then rooting for the exact thing that pops it. There's this idea that central banks are constantly in control of things. If there's one thing that will change that, it's the kryptonite of higher inflation."

Boockvar is referring to the fact that if inflation rises faster than expected, the Fed would have to tighten monetary policy sooner than expected as well. Considering the Fed's symbiotic relationship with markets, such a reduction in the efficiency of monetary policy could prove problematic.

Adding to a reduction in the efficiency of monetary policy would be the continued increase in zombie companies, which reduces the efficiency of the market. In a note last week, Yardeni Research head Ed Yardeni wrote:

"The Fed's solution to the zombie problem in the business sector is to exacerbate it by allowing corporations to borrow at record-low interest rates as investors continue to reach for yield by purchasing the bonds of lots of dodgy companies."

A bubble stock market populated with increasingly inefficient market participants that are being given access to an increasing amount of easy liquidity does not seem like the kind of bubble that will last forever.

The sweet spot?

Since there's no question that the Fed is aiming for increased inflation and indeed needs it in order to meet its goals of supporting the stock market and the debt market, the real question is whether or not it will be able to keep things in line with its target rate.

Chicago Fed President Charles Evans holds that ultra-easy monetary policy will be sustainable for years to come. In a speech last week, Evans said:

"The bottom line is that it will take a long time for average inflation to reach 2%. To meet our objectives and manage risks, the Fed's policy stance will have to be accommodative for quite a while."

The view that it would actually be very difficult for inflation to become high enough to achieve a long-term average above 2% is tied to the idea that investors are becoming too nervous about the high stock market valuations. This was highlighted by Fed Chairman Jerome Powell in a December interview with CNBC:

"The broad financial stability picture is kind of mixed I would say… Asset prices are a little high in that metric in my view, but overall you have a mixed picture. You don't have a lot of red flags on that…

Admittedly (price-to-earnings multiples) are high. But that's maybe not as relevant in a world where we think the 10-year Treasury is going to be lower than it's been historically from a term perspective."

In other words, as long as the Fed keeps interest rates at record lows and allows companies access to an increasingly large pool of liquidity at such rates, all while keeping inflation near or moderately above a 10-year average of 2%, Powell expects the stock market to remain in a sweet spot.

Conclusion

As 2020 reminded us, neither the stock market nor the economy are immune to sudden shocks – or previously anticipated ones, for that matter.

The Fed maintains that as long as it can keep its current ultra-easy monetary policies in place, everything will remain in a sort of sweet spot for stocks and bonds alike. However, it is possible that those very same policies could counteract the Fed's goals, which could force it to either tighten monetary policy or risk worse consequences for the economy.

For now, it seems that the Fed has things under control, but that might be part of the problem. All eyes are on the Fed, which means that if central bank policy makes any sort of turn that investors might consider unfavorable, or if it loses control of the inflation situation in the slightest, it could very well serve as the needle that bursts the bubble.

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