Among economists and central banks such as the US Federal Reserve, the Phillips Curve has long been a key policy determinant. The Phillips Curve says that when unemployment declines, wages are expected to rise. Extensions of the concept argue further that when wages rise, inflation is not far behind. Since 1980, the Fed’s policy actions have reflected the dual mandates of maintaining low unemployment and reduced inflation.
Except for occasional recessions, over the past 40 years unemployment has fallen. At the same time, inflation and interest rates have remained steady or drifted lower. Yet, worker’s share of income has also fallen. This burden has fallen mainly on the less educated, less skilled, younger population cohorts and has contributed to social unrest.
Consequently, the Phillips Curve became a topic of earnest debate in policy circles. Of course, we civilians heard little about it because, well, it’s economics. Which means that unless it involves millions of people losing their homes (2008) or their jobs (2020), economics is terrible content for “Breaking News Trivia!” and social media rage.
But this week, after several years of little noticed proceedings, the Fed announced landmark policy changes. A sea change in fact.
Inflation control is being replaced with a more flexible policy called “average inflation targeting.” The goal is to manage inflation so it averages 2% over time. Inflation might even be allowed to “run hotter” for longer before pulling in the reins.
Yet no one has said what the acceptable range of inflation might be, or what length of time will be used to calculate the average. Simply put, the inflation barn doors have been opened, That’s the opposite of policy that’s been in place since 1980.
That’s the backstory. What might we make of it? Is it good, bad, or just meh? Should we take any specific actions?
· First, expect a flood of punditry, advertisements, and breathlessly urgent warnings to “protect yourself from the coming financial disaster!” Develop a polite disregard for all that. Don’t pick up the phone now, and don’t click on that bait. One challenge or another will inevitably appear. They always do. But what they are selling is likely to produce more regret than satisfaction. Feeling jittery? Drop us a line or give us a call.
· Next, nothing dramatic is going to happen, regardless of policy, for at least another year, maybe two. The Fed has already told us interest rates will likely be anchored at the zero bound until 2022. There’s a pandemic to solve and a recession with millions of unemployed to get back on the job. Know that this is just going to be a grind, regardless of who gets elected.
· Lastly, dial down your beliefs and assumptions about expected portfolio returns. This is for two reasons:
(1) Interest rates in all maturities are at record lows. Interest income drives a big chunk of portfolio returns for most people. This chart illustrates the compression.The pickings are slim indeed.
(2) Most US stocks are being priced as if the pandemic is about to be solved and everyone will soon be back to work, school, restaurants, cruises, and sports venues. The chart below reminds us of a phrase we haven’t heard for a while: irrational exuberance. The three-standard deviation distance from the mean price-earnings ratio leaves little if any room for error. Put bluntly, this is a picture of risk.
Jim Cosgrove, CFP, Plano, TX
jim.cosgrove@verizon.net
972-489-0262
Jim Cosgrove, Partner, San Jose, CA jimcos42@gmail.com
408-674-6315
