CIO Update: The Fed’s New Take on Inflation
With the Fed’s announcement of their new approach to inflation, investors are now looking for ways to adapt their investment portfolios to respond to potential changes in the market. This week, Ryan McQuilkin, Head of Fixed Income, joins the CIO Update podcast to provide our perspective on the Fed’s policy going forward.
The Fed’s New Take on Inflation
Transcript Recorded on September 2, 2020
Shannon Saccocia: Hello and welcome to Boston Private Perspectives. I'm Shannon Saccocia, Chief Investment Officer at Boston private. This week we're going to be switching up our podcast a bit. With the Fed’s announcement last week of a new approach to their dual mandate of inflation and employment, I thought it'd be great to bring in our resident Fed expert Ryan McQuilkin to talk about how he sees this decision shaping policy going forward.
Ryan heads up the fixed income team here at Boston Private and helps me to set our investment policy and strategy as a member of the investment policy committee and our asset allocation working group. Ryan, Welcome to the Perspectives podcast.
Ryan McQuilkin: Hi Shannon. Good to be here.
Shannon Saccocia: Great. Why don't we dive right in? Let's start first with the question that's on everyone's mind. What exactly did the Fed do last week?
Ryan McQuilkin: Sure. So, it is a bit confusing at the recent policy review with Jackson Hole communicated that they are going to view inflation differently, especially as it pertains to hitting that famous 2% target. Essentially they have determined that, over the last several years, the US economy has sort of structurally changed, and they are now willing to let inflation run higher than maybe they would have previously. In the past, that would start getting cautious. They would maybe even preemptively raise interest rates as the economy got to full employment, believing that inflation was on its way soon. But you know they are changing their view on the somewhat; they no longer believe that a low unemployment rate necessarily leads to inflation.
As I mentioned, there has been some structural changes to the economy, namely aging populations and increased amounts of debt levels that are overall deflationary to name a couple, and also the Fed has just witnessed an 11 year expansion accompanied by low interest rates and also a low unemployment rate that did not lead to inflation. So that sort of informs this new view. Now you know the idea of letting inflation run above its target will especially apply, after years where inflation has failed to reach that 2% level, and sort of this entire view has been dubbed an average inflation targeting. So in practice, if for a couple years, inflation runs below that 2% level by maybe a percentage point, they would be willing to then let that inflation level run maybe a percent higher than that 2% of goal for a couple years afterwards.
Overall there was not a lot of fanfare for this announcement, especially considering the large scale intervention that they've undertaken this year and markets back in back earlier in the year, but this does have some implications going forward.
Shannon Saccocia: And this was really not much of a surprise, was it? I mean wasn't this really a formalization of things that had been talked about over the course of the last 12 or 18 months?
Ryan McQuilkin: It was. They've been talking about this, you know, off and on for several years, and really even this time they didn't put any firm guard rails around. There was no specific mention of numbers are trying to hit, or how many years they're going to have this policy in place. So it's still very flexible, if they gave themselves quite a bit of room to maneuver, but it does speak to a formalization of something they've been speaking about for a while.
Shannon Saccocia: So, with that is the backdrop, one of the things that we've been continuing to talk to our clients about as you're well aware is, what is fixed income look like in the New World? We've obviously gone back to zero interest rate policy, a place we've been several times over the course of the last decade or so. So, can you talk to me a little bit about how we view our outlook for bonds, given what happened last week and really given what everything that's happened since sort of mid-March?
Ryan McQuilkin: Yes, it's a very challenging environment right now, especially with rates at low levels with spreads at very tight levels, you know, there's not a ton of value about there. We, of course, remind our clients all the time that bonds have very important risk mitigation characteristics, and this probably does not have an immediate impact on overall interest rate levels. Right now we're sort of still under the specter of Covid-19 and the implications of the economy, essentially, still in repair mode as opposed to growth inflation mode for now. But down the road, this does have some implications that, you look at the markets last week and you didn't see forward inflation expectations increase modestly, but really the market’s taking sort of a wait and see approach. But, as we get past as we get past TCO bid you could see a steeper curve. You could see higher rates modestly, at least to start, over the next few years.
It probably argues for keeping portfolios on the shorter side in terms of duration wise and also sort of argues for probably keeping some dry powder available, whether that be in cash or cash alternatives or short term securities.
Shannon Saccocia: And that's really just one side of that yield curve steepening right? I mean it's the inflation expectations, but it's also those expectations for stronger economic growth, which I think you're starting to be priced into the market on the equity side. But to your point, we really haven't seen the yield curve price in robust economic growth in 2021 quite yet. Is that fair?
Ryan McQuilkin: That is definitely fair. I mean, coming out 2008, the curve got quite a bit steeper. You haven't seen that at all, certainly not yet, and the overall level of industry to certainly is certainly still very, very low with the 10 year around, about 70 basis points plus or minus.
Shannon Saccocia: So when we think about, you know, obviously here at Boston private we're managing globally diversified portfolios, to your point about risk mitigation, making sure that we're appropriately diversified across equities, fixed income, cash alternative, and so outside of traditional fixed income, which I know is your area of expertise. But can you talk a little bit about what other implications this might have for other asset classes based on what's happening here with the Fed?
Ryan McQuilkin: Yes. So, you know, it all depends on whether the Fed is successful in increasing that inflation. They’ve sort of been underperforming, under delivering on that part of their mandate for the last several years, and there are, as I mentioned, some structural headwinds to get into inflation, but if they are able to increase those expectations, drive those retire, it argues for allocating at least some of your portfolio to nutritional asset classes that have done pretty well to that backdrop, so gold, real estate, commodities. We've seen some more interest in tips lately. Overall, or at least client conversations to that effect, equities tour are of course a good place to be under an inflationary backdrop at least modestly. This new policy probably means a weaker dollar at the margin. So that has some implications for other asset classes as well.
Shannon Saccocia: So you mentioned tips and I just want to dig in a little bit more. You know what our views on tips, because I know that, in my experience, especially coming out of 2008 2009, there was so much talk about kind of runaway inflation with all of the monetary stimulus that we've seen. So, tips were on part of almost every conversation we were having over the course of a couple of years there and then, you know, obviously, we realized that inflation wasn't exactly happening, the way that it was anticipated. So how do we view tip as part of an allocation at this juncture?
Ryan McQuilkin: Yeah, it's a good point, and I think we're sort of under that same view, where we're taking sort of a wait and see approach. It’s a difficult nuance data class. It's a different asset class in terms of in terms of how it fits in the portfolio. But overall I think it depends on how long the outlook is, and right now we're just not believing that there's going to be runaway inflation.
Overall in tips you have to have sort of high inflation plus unexpected inflation, which are two things that are difficult to deliver and the track record of the economy and the things that are going on probably won't drive runaway inflation for a while if it ever does. So we're sort of focused on sales as well, still.
Shannon Saccocia: Great. Thank you so much. One last question. If you had to give you know a final word of advice for our investors who have bond allocations, and they are looking for questions that they should be asking their advisor either here at Boston private or elsewhere, you know, what are those one or two questions that you should be asking about your fixed income exposure in this environment?
Ryan McQuilkin: Yeah, I would think about why you want fixed income. You know, stay the course, remain flexible, think outside the box, and think creatively. Rates are low, but there are things you can do within fixed income and with different types of securities, different types of duration targeting, different types of asset classes and fixed income that can sort of mitigate the effects of lower interest rates, until we get to higher interest rate levels as well as sort of accomplishing the overall goal, which is to keep the volatility down the portfolio.
Shannon Saccocia: Great. Well, Brian, I really want to thank you for joining us today. I think that you shared an insight that will certainly prove beneficial for our listeners and we certainly look forward to having you back on in the coming months as the story unfolds.
Ryan McQuilkin: Great. Good to be here. Thank you, as well.
Shannon Saccocia: And thanks again for listening to this week's podcast. I want to encourage all of you to reach out to our team here at Boston Private with any questions or concerns you may have. Providing guidance and support as a trusted advisor is our mission. If you have any questions or thoughts on our points today. You can find me on twitter at Shannon Saccocia. You can also read our latest perspectives on the market, the economy taxes estate planning and fixed income by visiting BostonPrivate.com. And if you want all of this information delivered right to your inbox, I encourage you to sign up for our newsletters, while you're there. Be sure to subscribe to the Boston private perspectives on Apple podcast, Spotify, or wherever you prefer to listen, and I look forward to coming to you once again next week.
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