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• The Fed has shifted to an average inflation target, rather than a simple 2% level.
• It signaled that it will tolerate higher inflation, which will likely result in more-negative real interest rates.
• This has important implications for all major asset classes, including bonds and stocks.
Today, I focus on the Fed’s change in its targeting of inflation, announced by Chairman Powell last month. The Fed will now target inflation that “averages 2% over time,” rather than a simple 2% target as previously. If inflation runs below 2% for a while, the Fed will then “aim to achieve inflation moderately above 2% for some time.”
Corporate bonds, with their slightly higher yields, are barely making up for inflation. If inflation rises, then all bond investors will lose in real terms. This loss will come over time (if bonds are held to maturity) or sooner on a market-value basis, if the Fed lets interest rates rise. Rising rates would be devastating given the enormous debt load – but that’s a separate discussion.
The recent rally has brought stocks to extremely overvalued levels. The S&P 500 is trading at 3.8 times its book value – its highest since Jan-2001 (which preceded the 2001-02 bear market) and well above its 2007 and 2019 levels. In its 150-year history, Shiller’s P/E ratio has been higher only in 2018 and during the dot-com bubble of 1998-2001:
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