Hope Is Not A Risk Management Strategy
The Fed May Be Running Out of Good Choices
When fighting inflation threatens the economy—and protecting the economy risks more inflation.
The dilemma
For years, investors became accustomed to believing that the Federal Reserve would eventually come to the rescue.
When the economy weakened, the Fed could lower interest rates. When financial markets became unstable, it could provide liquidity. When borrowing costs became too burdensome, policymakers could step in and relieve some of the pressure.
But what happens when the Fed’s usual medicine could make the underlying problem worse?
That may be the position we are approaching today.
The Federal Reserve is confronting an uncomfortable combination: inflation remains too high, economic uncertainty is elevated, employment growth is losing momentum, and financial markets remain dependent on relatively favorable monetary policy.
The Fed still has choices.
The problem is that none of them are especially good.
“The greatest risk may not be that the Federal Reserve makes an obvious mistake. It may be that every available decision now carries a substantial cost.
The inflation argument
The case for keeping interest rates elevated
The Federal Reserve’s official inflation target is 2%.
Yet the Fed’s preferred inflation measure—the Personal Consumption Expenditures Price Index—was running at 4.1% over the year ending in May. Even after removing food and energy, core PCE inflation remained at 3.4%.
Overall inflation was more than twice the Fed’s stated objective, while core inflation remained well above it.
At its June meeting, the Federal Reserve maintained its federal funds target range at 3.5% to 3.75%. Its statement acknowledged that inflation remained elevated and specifically pointed to supply shocks and higher energy prices.
Under those circumstances, lowering interest rates could be dangerous.
Lower rates generally encourage borrowing, spending, speculation and asset-price appreciation. They can also weaken the dollar and make inflation more difficult to contain.
Cut rates too soon, and the Fed risks telling businesses, consumers and financial markets that it is willing to tolerate higher inflation whenever the economy becomes uncomfortable.
Once inflation expectations become embedded, restoring price stability can require much more economic pain later.
But that decision carries its own risks.
The economic argument
The case for lowering interest rates
Higher interest rates do not affect the economy immediately. Their effects accumulate gradually.
Every month that rates remain elevated adds pressure somewhere:
Homebuyers face less-affordable mortgage payments.
Businesses encounter higher financing costs.
Consumers pay more to carry credit-card balances.
Commercial real estate owners struggle to refinance maturing debt.
The federal government must devote more revenue to interest expense.
Banks and other financial institutions face greater stress from borrowers and depreciated assets.
There are also signs that the labor market may be losing momentum.
Those numbers do not necessarily indicate that a recession has begun. But they do suggest that the economy may have less room for error than headline stock-market performance would imply.
If the Fed leaves rates elevated for too long, it risks discovering that the economy was weaker than it appeared.
By the time the damage is obvious, it may already be too late to prevent a deeper slowdown.
And that brings us to the Fed’s dilemma.
The policy trap
Every direction creates a different danger
Lowers rates aggressively
- Inflation could accelerate.
- Energy and commodity prices could rise further.
- The dollar could weaken.
- Speculative activity could intensify.
- Already-expensive financial assets could become even more detached from underlying economic reality.
Keeps rates elevated
- Economic growth could weaken.
- Employment could deteriorate.
- Defaults and delinquencies could increase.
- Commercial real estate and banking pressures could worsen.
- Highly indebted consumers, businesses and governments could face increasing strain.
Raises rates
- It may improve the chances of eventually controlling inflation.
- But it could also expose financial vulnerabilities that have been building beneath the surface.
The minutes from the Fed’s June meeting reveal how divided the outlook has become. Many participants believed the appropriate policy rate could be at or slightly below its current level by year-end. Many others believed it should be above the current range. The Fed also removed language that had previously suggested a bias toward easier monetary policy.
Even inside the Federal Reserve, there is no clear agreement about which risk deserves the most attention.
The investor’s responsibility
Investors should not build a retirement plan around a perfect Fed decision
The Federal Reserve’s next meeting will receive enormous attention.
Commentators will debate whether rates should rise, fall or remain unchanged. Financial markets may move sharply based on a few words in the Fed’s statement or press conference.
But retirement investors should be asking a different question:
?What happens to my plan if the Fed cannot produce the outcome the markets are expecting?
That is the more important issue.
A retirement strategy should not require the Federal Reserve to lower rates at exactly the right time.
It should not require inflation to return smoothly to 2%.
It should not require highly valued financial markets to remain highly valued indefinitely.
And it should not depend on policymakers successfully protecting the economy, the bond market and the stock market at the same time.
That is too much faith to place in any institution.
What market prices can conceal
The risk of complacency
Financial markets can remain optimistic even while the range of good economic outcomes becomes narrower.
Investors may see stock prices near record levels and conclude that the underlying system must be healthy.
Markets often reflect expectations about what the Federal Reserve might do next. If investors expect lower rates, they may bid up stocks and bonds in anticipation of easier policy.
The danger comes when the reason for those lower rates is not favorable.
The Fed may eventually cut rates because inflation has been defeated and the economy remains healthy.
It may cut because employment is deteriorating, credit markets are under stress or an unexpected financial problem has emerged.
The rate cut itself does not tell us whether the news is good.
The reason behind it matters.
A better conversation
What retirement investors should be asking now
This is not necessarily a time for making dramatic decisions based on one economic report or one Fed meeting.
It is a time for examining assumptions.
How much of my retirement depends on financial markets remaining near historically elevated levels?
How would renewed inflation affect my income, expenses and purchasing power?
What would happen if stocks and bonds declined together?
Am I relying on the Federal Reserve to solve the next crisis as quickly as it solved previous ones?
Does my strategy include a plan for preserving capital and taking advantage of opportunities after a major market reset?
These questions are particularly important for retirees and those approaching retirement.
A younger investor may have decades to recover from a prolonged decline. A retiree who is withdrawing money does not have the same margin for error.
Losses experienced while taking distributions can permanently change the amount of income a portfolio can support.
The proper objective
Preparation matters more than prediction
I do not believe anyone can know with certainty what the Federal Reserve will do at its next meeting—or what the ultimate consequences will be.
The Fed itself does not know.
Its decisions will depend on incoming inflation, employment, spending and financial-market data. New geopolitical or energy disruptions could change the outlook again.
The objective should not be to predict every decision correctly.
The objective should be to build a retirement strategy that is not dependent on everything going right.
When policymakers are running out of good choices, investors need more than optimism. They need a plan.
The Federal Reserve may eventually bring inflation under control without causing a severe downturn.
