“We remain committed to using our full range of tools to support the economy for as long as is needed.”
-Jerome Powell – Chairman of The Federal Reserve, Tues, Sep 22, speaking to the House Financial Services Committee.
Just a week prior to that comment, Powell mentioned that he estimates that rates could remain low for another three years! Experience can teach us that in three months from now, let alone three years, he may be singing a different tune. Moreover, the full range of tools that he was referring to all pretty much have the same goal – keep interest rates low! The economic conditions we are currently facing beg for more stimulus, more activity. Powell has urged Congress to act accordingly and seriously consider more stimulus (more Government borrowing). The Federal Reserve’s fiscal policy contains mainly two methods to help “boost” the economy – 1) injecting massive amounts of money into the economy through the purchase of U.S. Treasury and corporate bonds, and 2) by lowering interest rates.
Please note: Even though the word “Federal” is part of the term "Federal Reserve," it has no association with the U.S. Government other than buying and selling U.S. securities from them. Another term used for the Federal Reserve is the “central bank,” or simply the “Fed.” So these government bond purchases are not an example of the Federal Government buying from the federal government. The Federal Reserve is a private entity that is privately owned - they' are no more "federal" than federal express.
There are technically no limits to how much money the Federal Reserve can pump into the system through bond purchases, but stepping back and viewing objectively, too much can’t be good. For one thing, the other side of the transaction when the Federal Reserve purchases U.S. government bonds is the U.S. Treasury is borrowing more money by issuing (selling) more bonds. The national debt for our country just surpassed $27 trillion dollars (a two, a seven and 12 zeros!) and it's estimated to grow higher due to the economic uncertainty caused by the global pandemic we are all dealing with. The interest cost alone for our current national debt is approximately $340 billion annually – and that’s with an interest rate of approximately 1.25% to 1.50%. If interest rates rise and our levels of debt are excessively high, the total annual interest would become a major component of the national budget.
For example, if interest rates on our debt rise to 4% and our national debt expands to $30 trillion dollars, our annual interest cost would be approximately $1.2 trillion dollars. Our annual defense budget is approximately $750 billion dollars; our annual Medicare/Medicaid budget is $1.3 trillion dollars.
Traditionally, what the Fed fears the most is increases to unexpected inflation. Although the annualized inflation rate has only been 2.1% since 2000, the potential threat of losing purchasing power, or experiencing negative “real” investment returns (inflation adjusted) as a result of prices rising faster than incomes has always been a major concern for the Federal Reserve. So what makes Powell’s remarks a little different from the usual was his reference to not allowing inflationary pressures influence fiscal policy as much as it has in the past. In other words, the Fed may allow inflation to reach, and even exceed, their 2% target rate without considering an increase in interest rates.
This apparent new Fed philosophy is good and bad. It may be good for the economy as businesses will continue to access “cheap” (low-interest) money to increase research and development, expand operations, and hire more employees – aka “trickle-down-economics.” But unfortunately, there is no compelling evidence that this downstream approach has achieved greater economic growth rates than the economy did when interest rates were higher.
But evidence does support that the group hit hardest from consistently low-interest rates are retirees. Why? Well, two things are happening: i) costs for important items included in the budgets of most retirees are rising faster than the national average based on the Consumer Price Index (CPI), and ii) investment returns on traditionally safe, conservative, assets such as savings, CD’s, short-term U.S. bonds, etc. are yielding ridiculously low returns. Higher prices for necessities coupled with low-interest rates make it difficult for conservative investors (mainly retirees) to keep up with rising prices, let alone a reasonable investment return.
What options do you have?
If prices for the items in your budget are increasing faster than your income, you are experiencing a “loss of purchasing power.” The same bag of grocery items costs more this year than it did last year with no matching income increases. The chart also highlights the impact the pandemic has had on prices for certain items Other income sources such as pensions and social security have an automatic cost-of-living adjustment tied to the CPI. But as I mentioned above, your individual situation may not be best represented by a national average.
In today’s current environment, you have a couple of options:
- Accept the lower returns and the potential purchasing power loss.
- This strategy protects the downside of your portfolio by keeping your exposure to risky assets either low or non-existent. You realize that many of your most important expenses may increase faster than the national average. Your financial resources are sufficient to cover your most important financial goals despite the annual loss of purchasing power. However, the longer the time this purchasing power loss is absorbed, the more financial harm it can inflict.
For example, assume an investor has a $100,000 investment earning an annualized 2% per year, but a 4% actual inflation rate on their expenses (assuming all income is paid out). Their investment will grow to $121,900 (no withdrawals or taxes) over 10 years, but $100K worth of expenses today will cost $148,025 at the end of 10 years – a twenty-six percent negative “real” return (purchasing power loss). Over 20 years the purchasing power loss would be approximately seventy-six percent.
- Construct a portfolio that can generate a return that is aligned with your risk tolerance, time horizon, and most importantly, your objectives and goals. It is possible to maintain a “conservative” portfolio and capture higher returns by utilizing the powerful effects of diversification.
Low Risk/Low Return 10-yr return (2010 - 2019)
One-month Treasury Bill .50%
6 month CD (range of rates last 10 years) .08% to .61% ¹
One to Three -Year Gov’t Bonds ² 1.20%
Medium Risk/Medium Return
Long-Term Corporate Bonds ³ 8.40%
Long-Term Government Bonds ⁴ 7.60%
High Risk/High Expected Return
U.S. Equities (U.S market) ⁵ 13.10%
Real Estate ₆ 11.60%
Higher Risk/Higher Expected Return°
Options and Futures Contracts
¹ Based on the national average for CD accounts under $100,000according to the FDIC.
² US Government Bond Index 1-3 Years
³Underlying data provided by Ibbotson Associates via Morningstar Direct.
⁴ Underlying data provided by Ibbotson Associates via Morningstar Direct. Includes US government bonds with an average maturity of 20 years.
⁵ CRSP Deciles 1-10 Index provided by the Center for Research in Security Prices, University of Chicago.
₆ Dow Jones US Select REIT Index.
° Higher risk assets become intricately complex and actual returns contain many different aspects.
As you can see from the chart, the more conservative you are with your investments, the lower the expected return. Choosing to invest in assets that can generate higher expected returns also means you are opting for a higher probability of losing value (risk) on your assets. This is a tough situation for individuals whose living expenses are mainly comprised of inflationary-sensitive items such as health care, housing, and food, and whose income is fixed or their investment returns are low. The unfortunate outcome is that many investors who are more comfortable with low-risk investments may have to accept more risk just so they can meet their increasing living expenses.
Carr Wealth Management, LLC, believes that creating investment portfolios that take advantage of low-cost vehicles, widely diversified holdings, long-term discipline, and tax-efficient strategies is a valid solution to achieving higher returns without accepting significantly more risk. Straightforward commonsense investment principles can be learned which will help make your investment experience a positive one.
Financial planning is more critical than ever right now. Our demographics indicate the majority of baby boomers are retired or retiring soon. The global pandemic has created many financial plans to be reviewed and updated. The number of financial issues that retirees face can be numerous, and receiving quality financial advice should be a priority. The financial goals and objectives of each investor remain the ultimate focus of any financial plan. Please visit our website and explore the various resources we offer to our clients or feel free to contact us and we can discuss your situation either by phone or meeting in a COVID safe environment.
Investing in securities involves risk of loss. No investment process is free of risk; no strategy or risk management technique can guarantee returns or eliminate risk in any market environment. There is no guarantee that our investment processes will be profitable. The value of investments, as well any investment income, is not guaranteed and can fluctuate based on market conditions. Diversification does not assure a profit or protect against loss. Past performance is not a guide to future performance.