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 Will
Low Inflation Continue?
Since
the mid-1980s, inflation has been much lower and more stable than it was
in the past. The high inflation rates of the 1970s detracted from the
country's standard of living, hindered capital formation and economic
growth, and took the country many years to overcome the adverse effects.
It is now generally believed that maintaining a low and stable inflation
rate provides lasting benefits to the economy, which is why it is one of
the Federal Reserve's primary monetary policy goals. As detailed in the
1977 amendment to the Federal Reserve Act of 1913, the Federal Reserve's
goals when setting monetary policy are "to promote maximum
sustainable output and employment and to promote stable prices."
In
recent years, inflation has changed in a number of ways:
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Movements
in inflation now convey less about future inflation. In the late
1970s and early 1980s, the most accurate forecast of future
inflation was an average of inflation over the past few quarters.
Sharp increases in inflation took a long time to reverse. Since the
mid-1980s, shocks to inflation have not lasted long. Thus, the best
estimate of future inflation is a very long average of past
inflation.
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The
correlation between inflation and unemployment has decreased. In the
1960s and 1970s, inflation tended to rise in periods when
unemployment was low and vice versa. Starting in the 1980s, this
correlation weakened substantially. Thus, a rapidly expanding
economy will tend to generate a smaller increase in inflation.
However, once inflation increases, it will be more difficult to get
it under control, since the economy will have to slow more to reduce
inflation.
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Changes
in energy prices have less impact on inflation. In the 1970s,
increases in energy prices had a significant impact on core
inflation, which is the change in consumer prices excluding food and
energy. Since the early 1980s, energy price changes have had little
impact on core inflation.
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Economic
volatility has decreased significantly in the United States. Since
the mid-1980s, output growth has been 50% less volatile and
employment growth has been two-thirds less volatile than the
previous three decades (Source: Business Review, Quarter 1,
2007). Inflation's volatility has also fallen substantially. |
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Inflation expectations significantly influence actual inflation.
Long-term inflation expectations vary over time, depending on economic
developments and current and past monetary policy. U.S. monetary policy
has become much more focused on low inflation, and the Federal Reserve
has been strongly committed to keeping inflation under control. During
the 1980s and 1990s, the Federal Reserve brought inflation down from
double-digit levels to approximately 2%, a level that has been
maintained for the past decade.
The
Federal Reserve has done such a good job that expectations about future
inflation have moderated significantly in recent years. Thus, when there
is a shock to inflation, the public believes that the Federal Reserve
will control the situation, so expectations about future inflation do
not change much, keeping inflation under control. A recent example is
the substantial increase in oil prices, which has not led to increased
inflation or a recession, as it did in the 1970s.
Will low
inflation persist for the foreseeable future? Like all questions about
the future, this cannot be easily answered. Inflation now reacts less
persistently to shocks, which is a result of better monetary policy and
inflation expectations. Now that the public believes that the Federal
Reserve will keep inflation under control, it acts in a manner that
makes the economy more stable. Thus, it would seem that interest rate
changes do not need to be as great to achieve stable inflation. But
these circumstances will only last as long as monetary policy meets the
public's expectations. Long-run inflation expectations must be monitored
closely, and the Federal Reserve must respond aggressively to shocks
that could have long-term impacts on inflation.
Back
to topics
 What
Is Happening with Long-Term Interest Rates?
Typically,
when the Federal Open Market Committee (FOMC) raises the federal funds
rate, long-term interest rates react by increasing also. However,
between June 2004 and July 2006, the FOMC raised rates 17 times in .25
percent increments, from 1% to 5.25%, and long-term rates barely moved.
In the
past, a 1% increase in the fed funds rate produced at 0.3% increase in
the 10-year Treasury yield (Source: Economic Letter, September
2006). Thus, with a 4.25% increase in the fed funds rate, you would
expect the 10-year Treasury yield to increase by 1.3%, but it only
increased 0.3%.
Similarly,
since 1980, the difference between the yield on 3-month Treasury bills
and 10-year Treasury notes has averaged 1.79% (Source: The Federal
Reserve Board, June 16, 2006). As recently as the end of 2006, the
difference was less than 0.5%. Currently, the difference is still only
0.8% (Source: Federal Reserve Statistical Release, November 26,
2007).
Why
haven't long-term interest rates increased as expected? Returns on bonds
have two components - the real component, which compensates investors
for the risk of loaning money, and the inflation component, which
compensates investors for expected inflation over the bond's term. In
recent years, both components have been trending downward:
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Real
component - The real component is also
called the term premium, since historically investors have received
a premium for increasing the term the bond is held. Since the
mid-1980s, economic growth has been less volatile, making investors
more confident about future economic stability, so they require less
return to hold longer-term bonds. It is also believed that demand
for long-term bonds has increased, while supply has not kept pace,
bringing down returns.
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Inflation
component -
Compared to a 5% inflation rate from 1980 to 1999, inflation in
industrialized countries averaged 2% from 2000 to 2004 (Source: The
Federal Reserve Board, June 16, 2006). Not only has inflation
decreased, expectations for long-term inflation are in the 2% range.
This has put significant downward pressure on long-term interest
rates. |
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The
behavior of long-term interest rates is not unique to the United States
- other countries around the world have experienced similar declining
patterns. The trend is so widespread that globalization of trade is
suspected to be a major factor. Since goods, services, money, and ideas
can cross borders so easily now, economies in different countries are
tied together more closely. Excess demand in one part of the world can
be filled by excess supply in another part of the world, evening out
economic activity in individual countries.
This has
major implications for monetary policy. Central bankers have control
over short-term rates, which is the primary means of implementing
monetary policy. Typically, when short-term rates are increased,
long-term rates follow. Higher long-term rates reduce consumption and
investment, which helps contain inflation. Reducing short-term rates
typically reduces long-term rates, which increases economic activity. If
those relationships no longer hold, monetary policy will be
significantly impacted.
Back
to topics
 Working
toward Your Financial Goals
To help
pursue your financial goals, you need a plan to help you get there.
These five basic tips can help:
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Set
exciting goals. Putting
money aside for a distant goal, rather than spending that money now,
is a difficult thing for most people to do. To make it easier, set
exciting goals that will motivate you to pursue them. For instance,
rather than "saving for retirement," make your goal
"to retire at age 60 with $1,000,000 in investments so I can
travel and golf." Then quantify your ultimate goal and interim
goals, so you'll have a way to track your progress.
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Consult
with a financial advisor. The number
of decisions that must be made to help ensure you meet your
financial goals can seem overwhelming. Even if you have a basic
grasp of some financial areas, you may be unfamiliar with other
areas. A financial advisor can help coordinate your entire plan,
making sure all financial areas are adequately considered. A
financial advisor can also monitor your progress. Sometimes you feel
more committed to goals when you know someone else is also watching
your progress.
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Determine
the financial issues that are causing you problems.
Almost everyone has difficulty coming to
grips with some aspect of their financial life. Perhaps your credit
card debt is becoming burdensome, making it difficult to find money
to save. Maybe you don't understand investing basics and have left
your money in a low interest-bearing savings account. Or you may
have totally ignored estate planning, leaving your spouse and
children at financial risk if you die. Whatever area is causing
problems, resolve to make strides in overcoming it this year.
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Spend
less than you earn. The
amount of money left over for saving is a direct result of your
lifestyle. Your lifestyle decisions will impact you now and in the
future, since you will typically want a similar lifestyle after
retirement. To get a grip on your spending, take time to analyze
your expenses and to set a budget. Try reducing nonessential
expenditures, such as entertaining, dining out, and vacations.
Another strategy is to find ways to spend less for the same things.
For instance, obtain car insurance quotes from several companies,
placing any premium reductions in savings.
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Save
it before you see it. If
you have to find money to save every month, you'll likely find there
isn't much left after all the bills are paid. Typically, a better
strategy is to set up an automatic savings program where money is
automatically deducted from your bank account every month and
deposited directly in an investment account. Another good
alternative is to sign up for your company's 401(k) plan, having
funds withdrawn every paycheck. Try to save at least 10% of your
gross income. (Remember that an automatic investing plan, such as
dollar cost averaging, does not assure a profit or protect against
loss in declining markets. Since such a strategy involves periodic
investment, consider your financial ability and willingness to
continue purchases through periods of low price levels.) |
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Back
to topics
 Your
Retirement Planning Assumptions
To enjoy
your retirement without financial worries, make sure you have enough
money saved when you retire. However, that calculation can be a daunting
task, since a variety of factors affect your answer and inaccurate
estimates for any factor can leave you with way too little in savings.
Some of the more significant factors include:
What
percentage of your preretirement income will you need?
You can find various rules of thumb indicating
you need anywhere from 70% to over 100% of your preretirement income. On
the surface, it seems like you should need less than 100% of your
income. After all, you won't have any work-related expenses, such as
clothing, lunch, or commuting costs. But look carefully at your current
expenses and how you plan to spend your retirement before deciding how
much you'll need. If you pay off your mortgage, stay in good health,
live in a city with a low cost of living, and engage in inexpensive
hobbies, then you might need less than 100% of your income. However, if
you travel extensively, pay for health insurance, and maintain
significant debt levels, even 100% of your income may not be enough. You
need to take a close look at your expenses and planned retirement
activities to come up with a reasonable estimate.
When
will you retire? Your
retirement date determines how long you have to save and how long
investment returns can compound. You want to make sure your retirement
savings and other income sources, such as Social Security and pension
benefits, will support you for what could be a very lengthy retirement.
Even extending your retirement age by a couple of years can
significantly affect the ultimate amount you need.
How
long will you live? Today,
the average life expectancy of a 65-year-old man is 81 and of a
65-year-old woman is 84. For a 65-year-old couple, there is a 25% chance
that one of them will live to 95. Most people look at average life
expectancies when estimating this, but average life expectancy means you
have a 50% chance of living beyond that age and a 50% chance of dying
before that age. Since you can't be sure which will apply to you, it's
typically better to assume you'll live at least a few years past that
age. When deciding how many years to add, consider your health as well
as how long other family members have lived.
What
long-term rate of return do you expect to earn on investments?
A few years ago, many retirement plans were
calculated using fairly high rates of return. Those high returns don't
look so assured now. At a minimum, make sure your expectations are based
on average returns over a very long period. You might even want to be
more conservative, assuming a rate of return lower than long-term
averages suggest. Even a small difference in your estimated and actual
rate of return can make a big difference in your ultimate savings.
Have
you considered inflation? Even
modest levels of inflation can significantly impact the purchasing power
of your money over long time periods. For instance, after 30 years of
just 2% inflation, your portfolio's purchasing power will decline by
45%. When estimating an inflation figure, don't just look at the
historically low inflation rates of the recent past. Also consider
long-term inflation rates, since your retirement could last for decades.
What
tax rate do you expect to pay during retirement?
Especially if you save significant amounts in
tax-deferred investments that will be taxable when withdrawn, your tax
rate can significantly affect the amount you'll have available for
spending. You may find your tax rate is the same or higher after
retirement.
Back
to topics
 Retaining
Financial Information
Feel
like you're buried under an avalanche of paper? The steady accumulation
of paper over the years can make even the most organized system seem
uncontrollable. Some general guidelines on which papers to retain and
which to toss include:
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Never
throw away copies of your federal and state tax returns, records of
gifts you made or received, deeds, birth certificates, or marriage
certificates.
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Retain
for at least six years any records that support tax deductions or
taxable income. Those records include canceled checks, expense
records, employment and other contracts, and tax-related forms such
as W-2s and 1099s. Keep in mind that the Internal Revenue Service
(IRS) has three years to audit your return, but can go back six
years if substantial underreporting of income is suspected. There is
no time limit if fraud is suspected.
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Keep
the cost records until the asset is sold plus six years, such as
brokerage statements reflecting the purchase and sale of securities,
other records detailing the cost basis of investments, contributions
to nondeductible and Roth individual retirement accounts, and
purchase and sale documents for significant assets, such as homes,
land, and cars.
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Monthly
or quarterly statements can be thrown away once you receive an
annual detailed listing of transactions at year end. Old annual
reports, proxy statements, prospectuses, and promotional information
can be tossed when you receive current information. |
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Keeping
your records organized will make it easier to find that paperwork when
you need it. Organized files will also help your heirs readily locate
all important financial information should something happen to you. This
will help them identify all your assets and liabilities and let them
know which professionals to contact, such as lawyers, accountants, and
financial advisers.
To
assist your heirs, be sure to gather and record details about safe
deposit boxes; life insurance policies; hospital, medical, and
disability insurance; homeowners insurance; employee savings and stock
plans; individual retirement accounts; credit cards; income tax records;
real estate records; outstanding debts; children's accounts and trusts;
savings accounts; investments; and advisers. Many of these records
should not be kept at home, but you should indicate where the original
documents are located. Make sure to note where birth, marriage, and
military records are kept, since these documents are usually needed to
collect benefits. Update this record annually, and make sure your family
knows where it is kept.
Back
to topics
Copyright ©
2007. This newsletter intends to offer factual and up-to-date
information on the subjects discussed, but should not be regarded as a
complete analysis of these subjects. The appropriate professional
advisers should be consulted before implementing any options presented.
No party assumes liability for any loss or damage resulting from errors
or omissions or reliance on or use of this material.
FR2007-0827-0057
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