Should you change your financial plan due to short-term changes in inflation and monetary policy?

by Massi DeSantis

The Federal Reserve Bank (“the Fed”) has been in the spotlight since the onset of Covid-19, taking a number of steps to help the economy weather the pandemic. You’ve heard of easy money, zero interest rates, reverse repos, quantitative easing, and you might be wondering what all of this means for your investments, especially with inflation made headlines again when we thought it was a thing of the past.

Inflation is an important risk to consider in any financial plan, and even more so for pension plans, where the planning horizon is longer. While we hope these Fed actions are for the best, some of the Fed’s monetary policy tools are new and less intuitive, and their discussion in the news may have amplified inflationary concerns. Let’s review the tools the Fed uses to control inflation and evaluate them in the context of a financial plan.

High and unpredictable inflation is not only bad for your plan, but also bad for the economy as a whole. Research shows that over periods and in countries with low and stable inflation, economic growth is generally higher than in periods and countries with higher inflation. Moreover, inflation is related to monetary policy and the amount of money in the economy. In periods and countries with high monetary growth, inflation is higher and less predictable than in periods and countries with lower and stable monetary growth.

The relationship between money supply, inflation and economic growth in the United States is controlled by the Federal Reserve Bank System or “the Fed”. The Fed is mandated by Congress to use monetary policy to promote both maximum employment and price stability.

easy money

The Fed controls the money supply by targeting a key interest rate, called the federal funds rate. This is the rate at which banks lend money to each other. Banks regularly lend and borrow cash reserves to meet their needs for funds for lending activities and for risk management purposes. Intervention in the fed funds rate market has been a classic primary tool of Fed monetary policy.

When the Fed lowers its federal funds rate target, it creates additional cash reserves that banks can use. The way the Fed does this is through what are called open market operations. For example, when the Fed wants to lower the federal funds rate, it can buy Treasury bills from a commercial bank. In doing so, the Fed sends money to the commercial bank, and the bank has additional reserves to lend to other banks. The additional supply of money has the effect of lowering the federal funds rate and potentially increasing bank lending, which can be positive when trying to stimulate the economy.

This is what we normally call an expansionist policy. Lower interest rates increase the money supply. If the increase in the money supply stimulates the economy, there may be little or no inflation. However, if the economy does not produce more goods and services, more money for the same goods and services will lead to higher prices and inflation. Currently, the Fed thinks the economy needs a federal funds rate target between zero and 0.25%, which is low by historical standards.

During the financial crisis of 2007-2008, the Fed realized that with low interest rates and acute problems in parts of the economy, old tools like open market operations to affect the fed funds rates alone might not be effective. The Fed has therefore designed new tools. Some of them are interest on bank reserves, quantitative easing and reverse repurchase agreements. The same approach has been used since the start of Covid-19.

Interest on bank reserves

Think of the Fed as the bank of banks. Commercial banks keep their cash reserves in an account with the Fed and the Fed pays them an interest rate on the reserves. Paying interest on reserves helps the Fed keep the federal funds rate within the desired target. Indeed, banks will be reluctant to lend reserves to other banks at a rate lower than that offered to them by the Fed. If the Fed wants to lower interest rates in the fed funds rate market, it will lower the interest rate on bank reserves so that banks can lend more in the fed funds rate market, which will lower the federal funds rate. Vice versa, the Fed can raise the interest rate on reserves when it wants to raise the federal funds rate.

Quantitative easing

The Fed engages in quantitative easing (“QE”) when it is willing to exchange cash for certain financial assets. In a traditional open market operation, the Fed buys or sells government securities like Treasury bills. In a quantitative easing operation, the Fed may buy or sell mortgage-backed securities, long-term bonds, and other types of loans from commercial banks and other financial institutions.

QE injects liquidity into commercial banks and the economy, much like traditional open market operations. Moreover, by targeting particular markets like the mortgage market and others, it can directly provide liquidity and stability to the target markets.

Reverse repurchase agreements

Reverse Purchase Agreements have recently been discussed in the news, and of the new tools, they are probably the least intuitive. In a reverse repurchase agreement, or reverse repurchase agreement, the Fed can sell a financial security to a financial institution like a money market fund or a government agency with the promise to buy it back the next day. From a money market fund’s perspective, it’s a way to deposit money at the Fed and earn interest overnight, until a more suitable investment is found. The interest rate paid on reserves is set by the Fed in the agreement.

Since the reverse repo is a risk-free investment for the money market fund, the fund will not be willing to lend the funds at a price lower than what the Fed offers to a commercial bank (in the interest rate market). federal funds). So, effectively, the reverse repo is a tool of the Fed to ensure that the fed funds rate does not fall below a desired level. Raising or lowering interest rates on these agreements helps the Fed keep the federal funds rate within a desired range. Reverse repos are particularly effective because they are accessible to a wider range of financial institutions than just commercial banks.

When the Fed wishes to achieve and maintain a target federal funds rate, it will use a number of available tools to do so, including open market operations, interest rate on reserves, and reverse repos. Maintaining the target may require changes, especially for reverse repo activity, which affects a wider set of financial institutions than just commercial banks. Lately, the Fed has increased reverse repo activity. When the Fed increases this activity, it tends to slow the growth rate of the money supply because it induces financial firms to deposit money with the Fed.

However, we do not know if this activity will change current interest rates on other investments or lower inflation. All we can assume is that the Fed is doing what it thinks is best to achieve its dual mandate of maximum employment and price stability. Interest rates and inflation will change due to many factors, including the actions of the Fed.

Inflation, the Fed, and Financial Planning

Over the past 100 or so years for which we have good economic data, the performance of the Fed in managing the money supply has been mixed, as our past experience includes periods of high and unpredictable inflation and periods of low and stable inflation. Although past experience does not help us predict the direction inflation is heading, it does provide a range of scenarios, and a good financial plan should take this into account. Determining how much to save for retirement, how much to spend in retirement and how to allocate your investments must take into account the risk of potential inflation.

This means that while the Fed and inflation may be in the headlines, it’s not obvious that you should change your long-term financial plan and investments in response to short-term changes in inflation and monetary policy, assuming you have a solid plan. If you are worried about the current inflation, here are some suggestions to mitigate its short-term effects.

  1. Postpone some of your major purchases. For example, keep your car a year longer than expected to avoid the price hike we’ve seen this year due to shortages, which may be temporary.
  2. Drive slower and less often by combining trips. You will notice a nice increase in mpg and a drop in weekly gas costs. Your tires, brakes and other auto parts will also last longer.
  3. Buy used. For most big ticket and entertainment items, the local Facebook Marketplace or Craigslist are great options. In most cases, you don’t really need a brand new stand-up paddleboard or DSLR camera.
  4. Review and revise your allocation to inflation-protected government securities, such as TIPS or I-Savings Bonds. These are government-issued bonds whose payments adjust to the consumer price index (“CPI”). TIPS can be purchased directly from the Treasury or through bond mutual funds and ETFs. There are limits to the amount you can invest in I-Savings Bonds, but they have very attractive interest rates that will adjust for inflation.

Inflation is an important risk to consider when developing a long-term financial plan. A good plan should already take into account the impact of inflation risk, based on historical experience. With such a plan in hand, you are unlikely to have to make drastic changes to your investing or spending behavior in response to short-term changes in monetary policy or current events. Rushing to buy gold or other commodities may not be in your best interest. Instead, make sure you have a solid plan in place and enlist the help of an advisor to help you do this.

About the Author

Massi De Santis is a paid financial planner from Austin, TX and founder of DESMO Wealth Advisors, LLC. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow and protect their assets throughout their lifetime. As a paid, fiduciary and independent financial advisor, Massi De Santis never receives a commission of any kind and has a legal obligation to provide impartial and trustworthy financial advice.