New Fed Policy Threatens to Disrupt Retirement Plans Nationwide

The Fed has vowed to fight inflation, now that prices have been surging for over a year. So what can the Federal Reserve do about it? Today we’re going to explain the two primary tools at its disposal, and how they change the retirement saving landscape…

New Fed Policy Threatens to Disrupt Retirement Plans Nationwide
Public domain image courtesy of the Federal Reserve

After months of turning a blind eye, the Federal Reserve now appears to be taking inflation seriously. Inflation is running at a red hot 7.5% pace year over year, so it’s a good thing the Fed is taking it seriously.

Here’s the problem: Inflation has a significant head start, and it’s been accelerating faster and faster since January 2021. That means it’s had a year to build momentum. So what can the Federal Reserve do about it? Today we’re going to explain the two primary tools at its disposal…

Fed’s #1 tool to combat inflation: Interest rates

Rate hikes announced during the FOMC meeting in December 2021, further explained in January 2022, are the Fed’s first and strongest tool to counteract rising prices.

According to a recent report from Wharton University in Pennsylvania, it looks like interest rates will increase at least “three times this year,” and possibly “five to seven times.” According to the same report, finance professor Nikolai Roussanov said we should expect,  “Three or four rate increases by the end of the year puts us at about 1% or 1.25% [from 0.25% now].”

Other sources anticipate faster rate hikes, as many as seven in 2022, and an end-of-year interest rate of 2%.

But rate hikes are only one tool the Fed has to combat inflation.

Fed’s #2 tool to fight inflation: Reducing asset purchases

According to the FOMC meeting statement in January, the Fed will slow its asset purchases in February, and stop purchasing Treasury bonds and mortgage-backed securities altogether pretty soon:

The Committee decided to continue to reduce the monthly pace of its net asset purchases, bringing them to an end in early March. Beginning in February, the Committee will increase its holdings of Treasury securities by at least $20 billion per month and of agency mortgage-backed securities by at least $10 billion per month.

That is a signal that the Fed is preparing to tighten its monetary policy. Quantitative easing will soon be over – in other words, the Fed will no longer be buying bonds in the open market. Chairman Powell is getting ready to turn the money printer off.

That means soon there’ll be fewer dollars sloshing around the American economy.

That’s good news, right?

Collateral damage

The same Wharton School report we quoted earlier outlines potential impacts on the U.S. economy. Whether the Fed continues implementing its plan as we described, or if at any point they stop.

Finance Professor Nikolai Roussanov explained:

It all depends on how dramatically markets behave in response to that, and whether the Fed still has the stamina to keep going through with these hikes over the course of the year.” The recent turbulence in the markets indicates that investors are “trying to process” the likely impact of those rate increases, said Roussanov. Growth stocks have already taken a direct hit over concerns of rising interest rates.

He expected the Fed to take a pause “if we see a serious pullback in the market — not what we have seen over the last week, but something that’s truly forecasting an immediate, impending recession.” The Fed “will ultimately pause on the hikes as they would need to compromise between the inflation-fighting goal and the speed of economic recovery.”

In other words, Chairman Powell’s Federal Reserve is stuck between a rock and a hard place.

That’s one reason retirement savers should keep an eye on what’s happening. The other is the potential impact on our retirement savings. As Professor Roussanov said: “all those 401(k)s aren’t going to look as good.”

Here’s a fast look at why…

Inflation & rising interest rates hit some assets harder

Rising rates impact all financial assets, but as Itamar Drechsler succinctly summarized, when the Fed raises rates, it effectively:

reduces the prices of assets such as stocks and real estate. The concern that the Fed will have to raise interest rates a lot has a powerful effect on all asset valuations, namely, to make them go down.

Higher interest rates are particularly problematic for these asset classes:

Growth stocks (especially tech stocks)

Business Insider explained this in a nutshell:

many technology companies are currently unprofitable or make little money. If bond yields are higher, then investors are losing out on returns in the here and now by holding tech companies that will only start earning properly in the distant future. That makes those firms look a lot less appealing.

Bonds (especially long-duration bonds)

Fixed income securities, also known as bonds, is generally considered safer than investing in stocks. During a period of rising interest rates, bonds (especially long-term bonds) just lose money:

Market interest rates and bond prices typically move in opposite directions, meaning higher rates generally cause bond values to fall, known as interest rate risk.

As a rule of thumb, the longer a bond’s duration, the more sensitive it will be to interest rate hikes, and the more its price will decline.

Savers can reduce this interest rate risk by investing only in short-term bonds (two years or less), explained certified financial planner Brad Lineberger, president of Seaside Wealth Management.

Housing and real estate

Lower interest rates increase demand for mortgages, and that boosts demand for housing and real estate. Higher rates have the opposite effect. As Desmond Lachman, a senior fellow at the American Enterprise Institute, explained:

Those bubbles in the equity and the housing markets, they've been premised on the assumption that interest rates would stay low forever. So, as soon as the Fed starts raising interest rates in an aggressive way, there's the real risk that it bursts the asset price bubbles… My expectation is you're going to have a lot of volatility [in] the year ahead, you know, and I fear that what we could very well see is the bursting of the asset and the housing market bubbles later this year.

That would impact home prices as well as commercial real estate. Remember the last housing market crash?

Lachman points out that “house prices, today, even if you adjust for inflation, they're higher than they were in 2006, before the last housing bust occurred.”

So a variety of assets will likely take a beating in the year ahead. And that’s not all…

Retirement planning gets a lot harder

As for inflation, retirement planning gets a lot harder when you can’t really determine how much you need in your account to enjoy a comfortable retirement.

One reason it can be challenging to factor high inflation into your retirement plan is most people don’t think of their savings in terms of “purchasing power.” Instead, most savers tend to equate their wealth to “how much money” they have saved.

We’ve covered this topic before, where we shared one Motley Fool article that explained why this matters: “[…] if you’re working now on saving $1 million for a retirement that’s 30 years away, your nest egg is going to be worth far less in real terms once you take inflation into account.”

Bottom line: Inflation always eats away at the buying power of every dollar you save.

There are diversification options that can help protect your savings against inflation. Whether you’re invested in Treasury Inflation-Protected Securities (TIPS), Series I Savings Bonds, or even physical gold and silver. (You can see how all “inflation-resistant” investments compare on our educational page that shows the pros and cons of each.)

And about diversifying your own hard-earned dollars into different asset classes…

Diversification is absolutely essential

The founder of value investing, Benjamin Graham, summarized why diversification is a key factor to a stable retirement portfolio. In simple terms, owning more assets is better than owning fewer.

But only diversifying into an increasing number of assets alone isn’t enough. That’s why Graham used a roulette wheel to illustrate how proper diversification works hand-in-hand with increasing the “margin of safety:

In American roulette,  most wheels use “0” and “00” along with numbers “1” through “36”. [...] A person betting $1 on a single number will be paid $35 when he wins but the chances are 37 to one that he will lose. The player thus has a “negative margin of safety”. The more numbers he bets on, the smaller his chance of ending with a profit. [...] Diversification in this case is therefore foolish. Suppose the winner received $39 profit instead of $35. In this case, he would have a small but important margin of safety. Therefore the more numbers he wagers on, the better the chance of gain.

You can see how different inflation resistant investments could increase the margin of safety in your savings. It’s also a great time to learn how gold performs over time and consider the benefits of well-diversified savings as a hedge against accelerating inflation and market volatility.

Remember, the best time to buy protection is before you need it.

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