Inflation Targeting and Politics

The Federal Reserve voted this week to raise interest rates by 0.25%, which was the second increase this year. Federal Chair Janet Yellen said that their decision to raise rates was a reflection of the progress that the economy has made.  Her two main points for raising rates were the 4.3% jobless rate at a 15-year low, and wage growth remaining weak. In her prepared remarks after the decision, Yellen stressed that there is an emerging debate over raising global inflation targets, which is now one of the Fed’s most important questions facing monetary policy.  Since early 2012, the inflation rate has been running below the Fed’s 2% target. In April, the inflation rate dropped to 1.7%.

There are many economists who believe that U.S growth is weak and that inflation should be increased to spur higher growth. I disagree with these shortsighted economists. I’m not sure how the economy can be weak if almost all the major stock indices are up over 15% in the past year. Moreover, there are now bidding wars breaking out in the real estate market. House prices are actually higher than they were before the entire economy system almost failed and needed a government bailout. The major differences between 2008 and now are that banks are well capitalized and borrowers are more creditworthy. The stock market has risen as corporate profit margins have increased. It’s been a very good investing environment and I don’t want any changes to inflation targets.

In addition, I know that all of my clients in retirement need lower inflation because of their fixed incomes. If the Federal Reserve does change their target to say 3%, the result will be that millions of retirees suddenly will be in a budget shortfall. Yellen believes that interest rates have been stuck at historically low levels and unless something changes around inflation targeting, growth will remain weak. She said that changing this inflation target “is one of our most critical decisions.” This is unwelcome news that the Federal Reserve does not believe that higher inflation is a major risk to investors.

When I create a retirement plan and change my inflation assumptions from 2% to 4%, the probability of a successful retirement drops substantially. It’s the real return that matters the most for investors. I prefer a lower inflation rate and a chance to make a higher return investing in stocks, bonds, and preferreds. I hope that the Federal Reserve can remain independent from Washington, keep to their senses, and continue to target an inflation rate of 2%. Regardless of your political affiliation, we don’t want any elected government officials playing politics with inflation targets in order to increase economic growth. The economy is running well and it will be best not to trigger higher inflation.

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