The Fed's new focus on employment above inflation has important investing implications

Published Fri, Feb 12 20212:15 PM ESTUpdated Fri, Feb 12 20216:27 PM EST

Key Points

The Federal Reserve is placing the employment end of its mandate above the inflation side.
That’s a reversal from previous policies where the central bank used interest rates to control price pressures.
Now the Fed says it will tolerate higher inflation in the interest of broad, inclusive employment gains.
Investing pros say there are multiple implications, with cyclical and tech stocks and even some bonds benefiting.

The Federal Reserve has long been thought of as first and foremost an inflation fighter, using its power over interest rates to maintain price stability in the U.S. economy. At least for the foreseeable future, that role is taking a backseat to a larger effort at getting America back to work. Under the central bank's new policy regime , the Fed now aims at not only full employment but also a jobs market that provides equal benefits across racial, income and gender lines. That means a focus away from what officials see as a long-term benign inflation picture and a concerted effort at a broad and inclusive jobs recovery. The ramifications are important on both an economic and investing level. Short-term interest rates anchored near zero are likely to remain in place for years , according to current Fed forecasts and market consensus. Along with that, Fed officials have said they expect to maintain the current $120 billion a month pace of asset purchases up through at least the end of 2021, with reductions in subsequent years likely to be gradual. It also means that the monetary policy juice that financial markets have relied on for more than 12 years will persist. "We've got to certainly get used to a new paradigm. It's almost as if this is the year the Fed decided it now only has one mandate, and that's full employment," said Art Hogan, chief market strategist at National Holdings. "They're going to move that second mandate to the back burner as it's asymmetric with their target." "I think the market still hasn't gotten its arms wrapped around what that means," he added. Investing implications Investors should take what the Fed says seriously and construct portfolios accordingly, Hogan said. That means a barbell strategy loaded with 5G-related tech on one hand and cyclical stocks such as energy, materials, industrials and financials on the other end. That type of strategy should persist through the Fed's employment quest as inflation remains low. The new Fed mandate puts employment "at the heart of the central bank's agenda to a greater extent than perhaps ever before," wrote Krishna Guha, head of central bank strategy at Evercore ISI. Easy Fed policy has helped boost the market off its March 2020 lows and thus far in 2021 also has been an important tail wind. An early warning sign that the trade could be ending is a sudden rise in the 10-year Treasury yield, said Hogan, echoing the comments of multiple other market pros. The benchmark government note has seen its yield more than double since early August 2020, and a similar fast rise in the future would indicate that the market is beginning to price in higher inflation ahead of the Fed. But that day seems a ways off, and Fed officials have said it will take more than forward market pricing to convince them that actual inflation, and not just fears of it, has taken hold. "We'd have to see inflation reach 2% not in a forecast but actually. So we are looking for actual inflation," Fed Chairman Jerome Powell earlier this week told the Economic Club of New York . Powell's emphasis on employment and de-emphasis on inflation "would sound remarkable to an earlier generation of central bankers," Guha added. That distinction is important, as the Fed in the past has used preventive rate hikes as a way to fend off inflation. That won't be happening under the flexible average inflation targeting approach. "He doesn't believe inflation is here, and it is really a message that they're going to keep rates lower for a long period of time," said Michael Yoshikami, founder of Destination Wealth Management. "Powell thinks the economy is too soft. Interest rates are going to continue to be low, as he has indicated, well into next year." The investment ramifications are multipronged, Yoshikami added. Whereas some investors might be prompted to ditch bonds can hold out now, at least for intermediate-duration fixed income. Bond investors fear inflation as it erodes their capital position as bond yields fail to keep up with the cost-of-living increase. Yoshikami said he also continues to be invested in stocks, with a focus on bond-like dividend payers that otherwise are unpopular with rising rates. Inflation in the pipeline Of course, a lot can go wrong with the Fed's employment mandate and its willingness to tolerate inflation that rises above what had once been considered a good yardstick for price stability. The economy grew 4% in the final three months of 2020 and is expected, according to the Fed's median outlook, to rise another 4.2% in 2021 which would be the fastest calendar-year GDP growth since 1999. The U.S. federal budget deficit is expected to be $2.3 trillion in 2021, and that doesn't include the current $1.9 trillion stimulus bill before Congress nor a likely second spending package coming from the White House later this year, according to the Congressional Budget Office. There are other inflationary pressures in the pipeline. The personal savings rate was 13.4% in the fourth quarter after rising 16% in Q3, indicating plenty of pent-up demand. Yet Yoshikami said if anything, he fears slower-than-expected growth brought on by difficulties in containing the coronavirus pandemic , even with falling case counts and declining hospitalizations. "Interest rates are going to remain low, so that's not going to be an impediment for the market," he said. "What is going to be an impediment is continued economic softness as the vaccine rollout and the new [virus] permutations cause problems. That's where the risk is for the market." Still, the Fed has long been considered to have a "third mandate" to keep financial markets humming, said Quincy Krosby, chief market strategist at Prudential Financial. While Krosby thinks Powell wouldn't be disturbed by a "healthy pullback," the push for full, inclusive employment is another incentive for the Fed to stay easy. "Absent an exogenous shock to the country, it's typically the Federal Reserve's moves that cause a break in a market that is doing extremely well," she said. "This market is underpinned by a Federal Reserve that is going to stay lower for longer."

A woman wearing a face mask rides a scooter past the U.S. Federal Reserve in Washington, D.C., the United States, on Jan. 27, 2021.

Lie Jie | Xinhua News Agency | Getty Images

The Federal Reserve has long been thought of as first and foremost an inflation fighter, using its power over interest rates to maintain price stability in the U.S. economy.

At least for the foreseeable future, that role is taking a backseat to a larger effort at getting America back to work.

Under the central bank's new policy regime, the Fed now aims at not only full employment but also a jobs market that provides equal benefits across racial, income and gender lines. That means a focus away from what officials see as a long-term benign inflation picture and a concerted effort at a broad and inclusive jobs recovery.

The ramifications are important on both an economic and investing level.