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Fed Meeting Ahead: How Inflation Impacts Interest Rates and Bonds

May 17, 2017
Man Calculating Inflation's Impact on Bonds

Like it or not, there are risks that can have substantial effects on your investments and inflation is one that can sometimes be overlooked. That’s why it’s important to learn inflation’s possible impact so you can make sure you’re not ignoring something that has the potential to reduce the purchasing power of your money.

Regardless of your age, it’s important to understand inflation and the risks it presents. It’s even more important if you’re nearing, or in, retirement. If you rely on income generated from fixed-income investments, such as bonds and CDs (certificates of deposit), a faster-than-expected rise in inflation could come as a nasty surprise.

Before we dive into how inflation impacts interest rates, and potentially your investments, let’s cover what inflation is.

What is Inflation?

We’ve all heard, or maybe told, the “back in my day” stories about how much more a dollar would get you and that’s thanks to inflation. Inflation is a sustained increase in the general price level of goods and services over time, resulting in a loss of purchasing power for a currency. There are thousands of indexes used to measure inflation, but two common ones in the United States are the Consumer Price Index (CPI) and the Producer Price Index (PPI). The CPI measures prices changes from the perspective of the buyer (consumer) while the PPI measures price changes from the perspective of the seller (producer). Each month, the U.S. Bureau of Labor Statistics gathers data on the price of tens of thousands of goods and services by surveying U.S. households and U.S. producers to determine inflation rates.

How Inflation Impacts Interest Rates

One of the Federal Reserve’s main goals is to keep inflation as close to 2% as possible using monetary policy—the actions taken by a central bank to control the supply of money to achieve interest rate or inflation targets. The target of 2% can change depending on economic conditions, but the Federal Reserve has currently decided this is the ideal rate to maintain a healthy economy.

When interest rates drop, consumer spending usually increases since it’s cheaper to borrow money, which can stimulate economic growth and result in higher inflation. When interest rates rise, consumer spending usually decreases since it’s more expensive to borrow money and higher rates can make saving more attractive. This can slow economic growth and result in lower levels of inflation, or even deflation—a decrease in the general price level of goods and services over time, resulting in a gain of purchasing power for a currency. 

Deflation might sound like a good thing from a consumer’s perspective, but it can have a detrimental impact on an economy if it persists. Ultimately, a low level of inflation, like the Federal Reserve’s target of 2%, is considered optimal for long-term economic growth.

How Inflation Impacts Investments

Since inflation and interest rates are intertwined, they’re important to consider when investing. Changes in interest rates and inflation can impact various asset classes in different ways. Historically, over the long-run, stock returns have outpaced inflation, but it’s not always possible or advisable to have a majority of portfolio allocated to stocks.

Inflation can impact fixed-income investments more than other asset classes since their coupon, or interest payment, is fixed. So far in 2017, the coupon, or interest payments, on 30-year Treasury bonds has been around 3%. With 2% inflation, your real rate of return is only 1% (real rate of return is an investment’s return adjusted for inflation and other factors like taxes, commissions and fees).  If inflation rises to 4%, your real rate of return is now negative 1% and your money is losing purchasing power.

Treasury inflation-protected securities (TIPS) are a special type of Treasury note or bond indexed to the CPI that can help protect fixed-income investors from losing purchasing power when the rate of inflation increases.  The interest rate an investor of a TIPS will earn will remain constant over the life of the investment, but the par value of the bond or note rises with inflation.  However, if interest rates were to rise in an environment of low or no inflation, TIPS’ prices could decline. 

If inflation starts rising faster-than-expected, the Federal Reserve could raise interest rates by a greater amount and at a quicker pace, which will cause the price of fixed-income investments, like bonds and brokered CDs, to decline. If you’re holding them to maturity, this isn’t as big of a concern since you should be repaid your principal barring a credit event like a bankruptcy.

Looking beyond fixed-income investments, commodities tend to perform well as hedges against inflation. Gold, and other precious metals like silver, have long been considered popular inflation hedges and historically they tend to rise in value as the dollar falls. Keep in mind that doesn’t necessarily mean they’ll continue to do so in the future. Precious metal ETFs have grown in popularity with investors trying to guard against inflation, but some of these can have high expense ratios that can eat away at returns.

Think of inflation as a hurdle your investing returns need to beat. If inflation is 2%, your investments need to return at least that so your money isn’t losing purchasing power.  

For help managing your investment strategy, or for guidance with developing a new one, visit the TD Ameritrade Goal Planning page, where you can find additional resources, as well as information about how to make an appointment to speak with a TD Ameritrade Financial Consultant.