The Federal Reserve’s Board of Governors has made clear its intention to gradually increase short-term interest rates in coming months. Many
in the financial media have gone much further by describing an all-but-certain increase in rates in general, to include intermediate and long-term rates.

The fact is the Fed has considerable control over short-term rates through targeting its fed funds rate and through its discount window, but little direct influence over the overall bond market, particularly long-term bonds.

Beyond the hard-to-predict forces of supply and demand for credit, long-term interest rates are determined in large part by expectations regarding price inflation. After all, bonds are fixed income instruments. Most provide semi-annual interest payments and a return of face value, both of which are fixed when the bonds are first issued. The purchasing power of these cash flows is eroded over time by rising prices for goods and services. So, bond prices and interest rates change in response to changes in inflationary expectations. Other factors equal, higher price inflation results in higher long-term rates as investors demand greater compensation (an “inflation premium”) for assuming this inflation risk. This is why 30-year Treasuries paid yields greater than 10 percent in the high-inflation period of the late 1970s and early 1980s.

Future price inflation is unknown, especially several years out, so long-term bond prices are more sensitive to changes in inflation expectations than are short-term bonds. Because we recommend bonds as a source of portfolio stability, most investors are best served by holding only short- and intermediate-term bonds and bond funds.

The market provides an estimate of future inflation. The Treasury issues conventional bonds as well as inflation-protected bonds (Treasury Inflation Protected Securities, or TIPS). TIPS differ from conventional bonds because they promise cash flows that increase automatically with prices as measured by the Consumer Price Index (CPI). Because they avoid the risk of unexpected inflation, their yields do not include an inflation premium. The difference in yields between conventional Treasuries and TIPS therefore provides the market’s estimate of expected inflation.

On this basis, the current outlook for inflation over the next decade is 2 percent per year, within the range of 0 to 4 percent annual inflation that we have experienced in the U.S. since the early 1990s. Those investors who are particularly averse to unexpected inflation, such as retired investors on a fixed income, should consider devoting a portion of their bond allocation to TIPS.

Also in This Issue:

Federal and State Death Taxes: An Update
Relying on Market Prices
The High-Yield Dow Investment Strategy
Recent Market Statistics
The Dow-Jones Industrials Ranked by Yield
Asset Class Investment Vehicles