Ivan Illan is Chief Investment Officer at AWAIM® and bestselling author of Success as a Financial Advisor For Dummies.
A profound event occurred in the early 2000s. There were several impactful events, but I’m not referring to the dot-com bubble burst, the 9/11 terrorist attacks, the Enron scandal, the euro being introduced, the Iraq War or the SARS outbreak. Instead, a quietly profound event happened in November 2002. After over 22 years, the U.S. inflation rate exceeded the effective federal funds rate for the first time.
Between November 1980 and November 2002, the Fed funds rate consistently exceeded the U.S. inflation rate. The average fed funds rate over those years was approximately 6.87%, while the average U.S. inflation rate was around 3.70%. Today, many market participants are anticipating a return to a very low interest rate environment, once inflation has been vanquished. However, history indicates otherwise, and the prudent investor would benefit from its perspective.
Per the aggressive monetary policy of then-Fed Chair Paul Volcker, the effective Fed funds rate had hiked to 22.36% on July 22, 1981, while the U.S. inflation rate for July 1981 was around 10.8%. At that moment, the Fed funds exceeded the inflation rate by a differential of about 11.56%, or 1156 basis points (bps). In contrast, after more than a year of recent Fed funds rate hikes beginning March/April of 2022, the effective Fed funds rate (as of Nov. 1, 2023) sits at 5.33% while inflation appears tamer at 3.70%—only a 1.63% or 163bps difference.
Ironically, 3.70% has been the long-term average for the U.S. inflation rate during the 22-year period mentioned earlier. Either the current Fed Chair Jerome Powell will win the Nobel Prize in economics for the most accomplished navigation of an inflationary crisis the world has seen in more than 40 years, or the current inflation fight and economic impact from recent years of ultra-accommodative monetary policy is far from over.
Regardless, the probability of returning to the ultra-low interest rate environment of the past 15 years is low—at least for the next several years. As money supply stabilizes and consumer demand remains strong, market prices will continue to inflate above the roughly 20% consumer price index (CPI) level increase that’s been experienced over the past three years. The probability of having deflation (where the price level declines) is somewhat likely, depending on the severity of the next recession.
The severity of the next recession could be primarily dependent upon the net effect of the so-called “maturity wall” being faced by the U.S. government and U.S. corporations. These entities have binged on debt issuance to record highs and now must refinance from all-time low interest rates as those debt piles come due. CFOs are not inclined to sacrifice their company’s credit rating.
As a result, to free up corporate cash flow, increased layoffs could impact widespread consumer demand. Demand reduction could shift market prices so that some deflation could be experienced. This could be helpful in the long term, but painful in the short term, while equity values struggle to maintain their footing due to falling revenues and profits.
There’s great news, however, for retirees and investors who are savvy enough to adjust their investment portfolios accordingly. The practical reliance on equity markets for growth and income over the past decade may no longer be necessary as marketplace interest rates now remain elevated well above the inflation rate.
The corporate capital structure can adjust to a more balanced cost of capital, dramatically curtailing financial engineering strategies like stock buybacks that have been financed with debt. This may remove a familiar boost to stock prices but could encourage capital flows to fixed-income instruments, which finally offer much more attractive rates of return.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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