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Recent double-digit equity returns obscure the fact that 4% to 5% return assumptions are prudent targets
from the end of fixed exchange rates, proved a conundrum. The psychology of spiralling inflation could not be broken until Federal Reserve Board chairman Paul Volcker boldly raised interest rates well in excess of inflation, exceeding 20% at one point in 1981, to choke off demand. Whenever inflation’s head popped up, the Fed “whacked” it with aggressive rate hikes. Note the large gap between the effect- ive funds rate and CPI after 1980 — until 2008 (Chart 3).
Chart 3: U.S. CPI over year earlier (%) and effective Fed Funds Rate (%) (January 1960 to November 2019)
Part 1 20 15
            Rates have fallen
and can’t get up
chance of loss for a given time period. Normally represented by short-term government bond yields, estimates for r* are shown in Chart 2 for the U.S. and for other countries (Can- ada, the Euro zone and the U.K.). The risk-free rate was over 2.5% before 2008 but has since stabilized below 1%.
10 5 0 -5
Source: Federal Reserve Bank of St. Louis; OECD
 Chart 2: U.S. and other risk-free interest rate estimates (1992–2018)
“Whack-a-mole” policy reduced U.S. core inflation and inflation volatility dramatically. Low inflation volatility is important in tempering expectations, suggesting lower interest rates for the near and intermediate future.
Average inflation (standard deviation of annualized quarterly inflation rates)
4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0
*Other = Canada, Euro zone and U.K.
Term premium
Other advanced economies
6.7% (3.8%)
1.4% (1.0%)
   The term premium has fallen over the past 20 years in the U.S. from 2% in 1988 to effectively zero since 2011, according to the Federal Reserve Bank of New York. “Whack-a-mole” monetary intervention and the expecta- tion of Fed vigilance against inflation have helped to drive and keep the term premium low.
Oil-price-induced double-digit inflation in the 1970s, complicated by plummeting stock prices and uncertainty
Source: Holston, Laubach, Williams (2017); Clarida (2019)
Source: Federal Reserve Board staff calculations;
Haver Analytics; Feenstra, Inklar, Timmer, American Economic Review.
If r* is 1%, inflation is 2% (Canada), and the risk pre- mium is effectively zero, expecting returns significantly above 3% requires explanation. Large pension plans have been reducing their return assumptions, or discount rates, as rates have declined. The Ontario Municipal Employees Retirement System is at 4% (down from 6% two years ago) and the Ontario Teachers’ Pension Plan is at 4.8%.
Recent double-digit equity returns obscure the fact that return assumptions of 4% to 5% are prudent targets for the coming decade. Using lower-cost vehicles is one of the most effective strategies advisors can employ to help clients address a low-return environment. AE
Shaded areas
are U.S. recessions
■ U.S. Consumer Price Index ■ Effective Fed Funds Rate
■ Other* ■ U.S.
 U.S. core
  5.2% (2.8%)
  1.8% (1.5%)
  Emerging markets
  32.7% (25.1%)
  5.6% (1.8%)
 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
Percent %
Percent %

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