The Fed’s U-turn on Inflation: Implications for Investors
Alex Bellefleur, M.Ec., CFA
Chief Economist and Strategist, Mackenzie Multi-Asset Strategies Team
Let’s step back from U.S./China trade tensions and consider a bit of economic history, starting with a trivia question: when was the last time that the United States experienced a genuine inflationary scare? The Federal Reserve’s preferred measure of inflation is the change in the core personal consumption expenditures (PCE) price index, which is targeted at an annual rate of 2%*. If we consider an inflationary scare to constitute inflation higher than 3% for over a year, the last time we had such a scare was in… 1992, when the Toronto Blue Jays were World Series Champions and George H. W. Bush was President. This is indeed a long time ago!
The absence of inflationary pressures has become even more pronounced in recent years. Over the last decade, this measure of inflation averaged a mere 1.6% per year, falling well short of the Fed’s 2% target. This does not seem like a big deal at first sight, but on a cumulative basis over a 10-year period, this persistent inflation undershoot translates to approximately 5 percentage points lower in the level of the price index. This has central bankers worried because: 1) it puts the credibility of the Fed’s inflation target in jeopardy, and 2) it increases the likelihood of outright deflationary pressures in an eventual economic downturn. Central banks want to avoid deflation at all costs predominantly because it pushes consumers to delay purchases (as prices are expected to fall), and it increases the size of debt burdens in relation to incomes.
It now appears that many Fed policymakers are growing uneasy with the risk of inflation which remains too low for too long. For this reason, an idea that is now making the rounds is that of a symmetric inflation target, or the deliberate acceptance of an inflation overshoot to make up for past undershoots. For example, this means that the Fed could tolerate inflation at 2.5% for some time to make up for all the time spent with inflation at 1.5%.
This has important implications for investors. It explains partly why the Fed is beginning a rate cut cycle despite broadly stable U.S. growth numbers. There are signs of weakness in the manufacturing sector and global trade tensions do portend some element of risk, but for now, the U.S. consumer remains alive and well, with retail sales growing at approximately 4% per year. In other words, we believe Fed rate cuts will be taking place more for disinflation reasons than for growth reasons.
In our view, this scenario is a positive one for both equities and bonds over a tactical horizon. On the fixed income side, rate cuts are typically supportive of bond returns, as the yield curve moves lower and becomes steeper. This certainly has been the case so far this year, and we increased our weight in fixed income assets during the second quarter. For equities, rate cuts can help rekindle earnings growth expectations. Some of these rate cuts are already priced into both the equity and the bond markets. However, we think there is a chance that the Fed’s significant policy re-think could persist well into 2020, especially if inflation continues to be held lower by technological and demographic factors despite a robust labor market. This is a prospect which supports our current tactical positioning, which is reflected in our Symmetry funds as well as in our alternative strategies (Mackenzie Multi-Strategy Absolute Return Fund and Mackenzie Global Macro Fund).