If the Fed can't get inflation down, stocks will be the best bet for your money

By Peter Morici

Investing for retirement, college and other longer-term goals should favor stocks over bonds

Federal Reserve Chairman Jerome Powell has focused America's businesses and households on how much longer interest rates must be kept elevated to achieve 2% inflation.

Nothing is magical about this 2% target. The figure lacks a firm basis in economic theory and empirical research. Rather, it represents a consensus of convenience among the tightly woven community of central bankers about the tradeoff between accomplishing price stability and maximizing employment.

As former Fed Chair 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."

If anchored in household expectations, 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 where demand chronically exceeds supply and inflation rachets up, as it did in the 1970s.

Currently, P* is not so low that businesses are reluctant to invest because of fear that slack demand would cause prices to decline and make servicing debt overly burdensome.

The 2% inflation target harkens back to 1989, when New Zealand's central bank settled on that figure. The idea seemed sensible, spread to central banks in Canada, Sweden, Britain and elsewhere, and was formally adopted by the Fed in 2012.

Unfortunately, P* is not fixed. Between the 2008 Global Financial Crisis and the COVID-19 pandemic a dozen years later, the Fed's monetary policy was often quite accommodating, yet inflation averaged just 1.5% from 2009 to 2020 without noticeable effects on investment.

Globalization enabled by World Organization tariff cuts, China's entry into the system in 2001, and progressive industrialization in China and across Southeast Asia increased competition and suppressed prices for goods and tradeable services.

Nowadays, globalization is realigning as businesses seek to better secure supply chains in response to the risks imposed by U.S. and European tensions with China, Russia and Iran. Though COVID-era disruptions are behind us, close to half of U.S. manufacturers still face difficulties obtaining components and materials.

Relief spending in response to both the Great Financial Crisis and COVID has left most major Western economies strapped with debt. Geopolitical tensions add 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 savings to finance retirement. This will cause aggregate demand to outrun supply or at least challenge it.

P* - the optimal inflation target - in fact could prove to be much higher than 2%. Slavish adherence to achieving a 2% inflation rate could cause chronic fits and starts of monetary tightening and for inflation to climb, similar to the years before former Fed chair Paul Volcker slayed the great U.S. inflation dragon in the early 1980s.

Nowadays, respected macroeconomists and U.S. Treasury Secretary Janet Yellen are suggesting 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 U.S. interest rates that prevailed the decade preceding COVID.

Whether the Fed accomplishes 2% inflation or concedes to aim higher, long-term U.S. interest rates, as measured by the 10-year Treasury, BX:TMUBMUSD10Y, should be much higher than the 2.35% average that prevailed between 2009 and 2020.

If sustainable inflation is 3% to 4%, for example, then the 10-year Treasury rate should be 5% to 6%. Bond prices decline when rates rise, so investors should recognize that the long-term bonds they hold, directly or in savings vehicles such as IRAs and college-savings portfolios, would lose value as both inflation and interest rates edge up.

Read: Forget about your retirement portfolio beating inflation over the next 10 years

Interest-rate risk even applies to seemingly safe U.S. government bonds. Though longer-term government bonds are paying better than pre-COVID - the 10-year Treasury rate is currently 4.3% - investors face asymmetrical risks of capital losses if bonds are not held to maturity.

In response, some portfolio managers are shifting investments toward stocks, real estate and natural resources, but the latter two choices are tough for ordinary investors to evaluate.

Instead, larger companies - such as those that dominate the S&P 500 SPX- often have pricing power to profit from inflation, along with expertise to capitalize on artificial intelligence and the ability to navigate challenging supply chains and other forces of change.

More than ever, investment decisions to fund retirement, college and other longer-term goals should favor stocks over bonds. For stocks, create a diversified portfolio of at least 10 stocks or purchase a low-fee S&P 500 index fund. Bonds and other fixed-income assets can provide stability and should be structured to mature when the cash is needed.

Peter Morici is an economist and emeritus business professor at the University of Maryland, and a national columnist.

Plus: Powell says inflation is showing signs of resuming cooling trend

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-Peter Morici

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07-02-24 1852ET

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