The Fed’s Dangerous Game — And What To Do About It

Interest rate policy can be boring.

I’m reminded of this every six weeks as the Federal Reserve meets and Wall Street’s attention turns towards the Eccles Building in Washington, D.C. For years, CNBC has used the building as the backdrop for reporters when the Fed meets — as they were yesterday.

Each time the Fed meets, traders anxiously wit to see what happens. Traders watch the news, largely consisting of a reporter standing in front of a building saying things like, “There’s a meeting going on inside.” Analysts will try to explain what members of the Fed were thinking at the meeting.

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The Fed’s thinking is nearly impossible to understand, but the Fed’s goals are relatively straightforward. The Fed operates under a mandate from Congress to “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

This mandate, in effect, tells the Fed to do everything possible to preserve the American dream.

Economists have long believed there is a close relationship between employment and prices. This relationship is quantified with the Phillips curve. The idea is that inflation and unemployment move in opposite directions, exhibiting what economists and mathematicians call an inverse relationship. Low unemployment should lead to high inflation, and high unemployment should lower inflation. (See also: Why This Latest Fed Cut Is Different)

In trying to attain maximum employment with stable prices, the Fed is looking for the point where unemployment is low, but not too low. The primary tool for influencing prices and employment has long been the interest rates the Fed controls.

I feel like this is largely an academic exercise for many investors. The reality is that Fed policy is among the most important factors affecting retirement for many Americans.

If the Fed fails, inflation can take hold. That can be seen in the chart below, which highlights the late 1970s and early 1980s. This chart shows inflation (the red line) and interest rates on Treasury bills (the green line).

When inflation was more than 10% a year, interest rates on three-month Treasuries was near 15%. Unemployment was consistently between 7% and 10% over that time, twice today’s level.

This is the problem the Fed is working to avoid.

It’s interesting to notice the speed at which inflation moved at that time. Once it gained traction, the Fed seemed powerless to stop it. That is an experience that policy makers have worked to avoid ever since.

If the Fed loses control, as it has in the past, the results could be catastrophic for income investors. That’s one of the reasons I focus on short-term income opportunities. If inflation starts rising, equity prices will rapidly adapt by falling. And we’ll be in a position to react quickly by making only short-term trades.

Of course, we all hope the Fed will maintain control of inflation, as it has for almost 40 years. But I believe we, as investors, need to stay diligent.

When I see changes in the data, I will alert my premium readers first. But rest assured, I’ll be talking about it in these pages, too. For now, I expect more of the same – low interest rates, low inflation, and lower-than-average long-term returns from equities in the next few years. (Related: Bad News For Long-Term Investors. Here’s What To Do Instead…)

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