OPINION:
Federal Reserve Chairman Jerome Powell has Fed policymakers and America’s decision-makers — businesses that set prices and households who choose among goods to purchase and investment options — focused on how much longer interest rates must be kept elevated to achieve 2% inflation.
There is nothing magical about 2%. That goal lacks a firm basis in economic theory and empirical research and represents a consensus of convenience among central bankers worldwide about the trade-offs between achieving price stability and maximizing employment.
As former Fed Chairman Alan Greenspan put it, “Price stability is that state in which expected changes in the general price level do not effectively alter business or household decisions.”
The optimal inflation target (P*) is not so high that consumers rush to spend today in anticipation of higher prices tomorrow. That would encourage spending at a pace at which demand chronically exceeds supply, and inflation would rocket up as it did in the 1970s.
P* should not be so low that businesses are reluctant to invest. It shouldn’t create fear that falling prices would make servicing debt, which is essential to most enterprises, overly burdensome in periods of slack demand.
When pressed by legislation in 1989, central bankers in New Zealand came up with 2% in an offhanded way. But the idea seemed sensible, spread to central banks in Canada, Sweden and elsewhere, and was formally adopted by the Fed in 2012.
Unfortunately, P* is not fixed.
Between the global financial crisis of 2007-2009 and COVID-19, the Fed’s monetary policy was often quite accommodating, yet inflation averaged only 1.5% from 2009 to 2020.
With the availability of inexpensive labor and industrialization in China and elsewhere in Southeast Asia, globalization accelerated by World Trade Organization tariff cuts, and China’s entry into the system in 2001 did much to suppress prices of goods, but now things have flipped.
Globalization is undergoing realignment as businesses seek to harden supply chains in response to the risks imposed by U.S. and European tensions with China, Russia and Iran. These create difficulties for many U.S. businesses in securing the goods they need to make products and deliver services.
Financial crisis and COVID-19 relief spending have left governments in most major economies strapped with debt. Given the above-mentioned geopolitical tensions, they are under pressure to borrow even more to boost defense spending.
These forces will persist alongside an aging global population that will liquidate assets — older people in many countries drawing down the equivalent of IRAs to finance retirement. This will cause aggregate demand to outrun supply or at least challenge it.
P* could prove much higher than 2%, and slavish adherence to accomplishing 2% inflation could cause chronic fits and starts of monetary tightening and for inflation to ratchet higher, similar to the years before then-Fed Chairman Paul Volcker slew the Great Inflation in the early 1980s.
Notable macroeconomists and Treasury Secretary Janet Yellen suggest that the neutral rate of interest (R*), which is high enough to keep inflation reasonably steady but not so high as to stifle growth, is greater than the interest rates that prevailed in the decade preceding COVID-19.
Whether the Fed achieves 2% or concedes to aim higher, long-term interest rates, as measured by the 10-year Treasury rate, should average much higher than the 2.35% achieved from 2009 to 2020.
If sustainable inflation becomes 3% to 4%, the 10-year Treasury rate would be 5% to 6%. Rising from present levels would reduce the market value of long-term bonds currently in investors’ portfolios.
Individual investors need to recognize that long-term bonds, such as those held in IRA funds with retirement targets and college savings portfolios, are at risk of losing value as inflation and interest rates rise.
That interest rate risk even applies to seemingly safe U.S. government bonds.
Though longer-term government bonds are paying historically high interest rates — the current 10-year Treasury rate is somewhat above 4% — investors are at risk of taking capital losses if bonds are not held to maturity.
Some portfolio managers are shifting investments toward equities, carefully selected property and resources, but the latter two choices are tough for ordinary investors to evaluate and spread risk.
Instead, recognize that larger companies — such as those that dominate the S&P 500 — often have the pricing power to profit from inflation, technological expertise to benefit from the great forces of change such as artificial intelligence and de-risking supply chains, and heft to diversify risks in property and commodity markets.
More than ever, good long-term investing for retirement or young children’s college funds should veer toward stocks rather than bonds. Ordinary people should plan to purchase bonds or fixed income assets that mature when the cash is needed.
My money is in low-fee index funds, like the Vanguard and USAA S&P 500 funds, and I wouldn’t recommend a choice I don’t pursue myself.
• Peter Morici is an economist and emeritus business professor at the University of Maryland, and a national columnist.
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