Improving Transparency

The Federal Reserve today, for the first time, provided guidance on interest rates and an official estimate of inflation as part of its regular FOMC meeting. The Fed announced that, given its expectations for continued sluggish economic recovery and elevated unemployment, it does not expect to raise interest rates until 2014. The Fed also provided for the first time a specific inflation target of 2%.

There are a few important messages in this announcement. From a purely economic perspective, it is clear the Fed remains concerned about the pace of economic recovery and, at least for now, it does not view inflation as a problem. From the perspective of “communications”, there are also a couple of important messages. The Fed is trying to provide improved “transparency” to investors which, in turn, it believes will increase confidence in businesses’ willingness to make capital investments and hire new employees. Improved transparency should foster a higher level of trust in the Fed, or at least reduce the level of conjecture and uncertainty surrounding Fed policy which has greatly added to market volatility over the years. The idea here is improved transparency may reduce systematic risk to some degree.

So if the Fed is correct in its forecast for interest rates, there are number of issues that come up from a financial planning perspective. Sustained low interest rates reduce returns available from bonds which hurts individuals who may need higher levels of bonds in their portfolios. Lower returns may also force investors to rely more on certain equities for income, which could increase portfolio risk

As financial planners we can mitigate these risks in a number of ways. Investing in bonds issued by certain foreign countries can be a source of higher yields. For example, bonds issued by certain emerging market countries offer good credit quality at significantly higher yields than investment grade U.S. bonds or Treasury bonds. Certain categories of corporate bonds can also offer higher yields than U.S. Treasury or agency bonds. Investing in certain sectors of the equity market, such as preferred stocks, utility stocks, REITs, and quality high dividend-paying equities can also be a way to enhance portfolio cash flow or meet portfolio income requirements in the situation of very low bond yields, which we are experiencing now.

Striving for improved transparency has implications for financial planning as well as Federal Reserve policy. Greater transparency of things like plan goals and objectives, investment strategies, custodial relationships, financial statements, and accessibility, goes a long way to enhancing trust between client and financial planner. Given the headlines of the past few years, we can understand why people would be looking for greater transparency from their financial advisors. As the Fed is realizing, improved communication with important constituencies can not only increase trust, but also reduce risk.