If you follow financial news, you will have seen reports about the Federal Reserve’s new inflation target. Rather than using their goal of a 2% cap on inflation, the Federal Reserve would like to see inflation average 2% over an extended period of time.
This sounds like a subtle change, but it may have big repercussions.
Why does the Fed want a higher rate of inflation?
A continual low level of inflation is desired. When [consumer] prices are going up, people want to buy now rather than pay more later. This increases demand in the short term. As a result, stores sell more and factories produce more now. They are more likely to hire new workers to meet demand. It creates a virtuous cycle, boosting economic growth. [Source]
This boost to the economy is what the Fed is trying to create. A little boost would help get us out of the coronavirus slump. If the boost is allowed to continue uncapped, however, things could get out of control.
I believe that by removing their 2% cap on inflation, the Federal Reserve is returning to the Alan Greenspan years. With Mr. Greenspan as Chair, the Federal Reserve did not preemptively raise interest rates to keep a lid on the economy. They raised rates too late.
Throughout the 1990’s the economy grew until peaking with the Dot com bubble bursting in 2000. Then in 2007 we had the housing bubble. In both instances, the Federal Reserve did not raise interest rates quickly enough to keep inflation in check.
It was after these two bubbles that the Federal Reserve switched to the idea of capping inflation in January of 2012. Now they are going back again.
I reason that if the Federal Reserve goes back to its previous policy, then we should expect the same results. I think we will again see bubbles, and most likely, they will be in the same places as last time.
One could argue the stock market is already approaching a bubble in tech and other popular stocks like Tesla. Since the Coronavirus-19 lockdown many people have felt that tech stocks are a can’t lose investment and have been continually buying. The tech company Snowflake became the largest IPO ever, but it doesn’t make a profit. Sounds a bit like 1999.
There is a reason that tech stocks and real estate were the two places for bubbles last time and possibly next time. With low interest rates like we have now, there is no income reward for owning bonds. Earning 0.85% per year on a 10-year Treasury bond is not a worthwhile investment for a lot of people. Therefore, they move their money where they will get returns. That means stocks and real estate.
If the Federal Reserve delays raising rates, there is going to be easy money around for several years. Where will that easy money go? Into business investment (stocks) and into real estate.
As investors we need to stay with the investments that are going to attract cheap money and benefit from low interest rates. That means continue to own your stocks and buy real estate (REITs or individual properties) if you don’t own some already.