The Federal Reserve and Your Retirement Nest Egg

The Federal Reserve announced a policy change this week that baby boomers should pay close attention to. For the past few years, the Fed has told the public that the interest rates it controls would be maintained at or near 0% until at least 2015. That has now changed because the Fed has instead tied its interest rate policy to the unemployment rate. On Wednesday, the Fed said it would maintain interest rates near zero if  the unemployment rate remained above 6.5 percent, further provided that inflation does not rise above 2.5 percent.

Let’s think about what this means. Retirees and retirement savers are not big fans of low interest rates. Also, many of us have reallocated our retirement investments to reduce equity exposure and increase bond exposure. The value of bonds is inversely proportional to interest rates, i.e., when interest rates increase, the market value of bonds we own (and bond funds) goes down.

Now we have a second specific metric to watch to anticipate upward movements in interest rates caused by Fed action: the unemployment rate. (The other metric is the inflation rate.) As unemployment keeps falling towards 6.5%, we can expect the Fed to push interest rates upward. If you own bonds or bond funds, you can expect their value to begin to fall as the market also anticipates Fed action when the 6.5% threshold is reached. This is when you should consider selling those bonds or bond funds. (If you are planning to hold individual bonds to maturity, this is not a concern.)

Of course, if inflation spikes upward, the Fed could act before unemployment reaches 6.5%. This is when owning a short duration TIPS fund or ETF could be helpful. The increase in inflation will likely increase the market value of the TIPS fund. The increase in interest rates should have less of a negative impact on funds holding short-duration bonds. This is why I am looking at moving some money into VTIP, Vanguard’s new short duration TIPS fund.

What do you think about this strategy?


Comments

    • MJP says

      I own a longer duration TIPS fund as well. However, the longer duration TIPS are more susceptible to interest rate risk, so owning a shorter duration fund as well should somewhat offset that risk.

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