Blog, Investment Management

Interest Rates, Inflation, and Investment Strategy


While market conditions may be uncertain and subject to noise, our commitment to providing patient and personalized financial advice remains unwavering. The timeless tenets that guide our approach are enduring and even more relevant in times of heightened volatility. As we help people navigate their financial interests through different market conditions, we remain steadfast in our dedication to upholding these core principles.

Part 1: Understanding Interest Rates

What’s Up With the Fed Rate? 

Almost everyone is familiar with interest rates. That said, far fewer know what to make of the Fed’s target funds rate. Everyone from economists to politicians to the financial press seems always to be talking about them. Markets rise or fall when the Fed comments on them. They’re often treated as synonymous with interest rates in general. They must be important, right?

Well, yes, the target funds rate is important. But not in the way you might expect. 

As the central bank for the United States, the Federal Reserve is tasked with setting monetary policy to promote “maximum employment, stable prices and moderate long-term interest rates … thereby supporting conditions for long-term economic growth.” In this supporting role, the Fed uses its target funds rate as one of many “levers” to achieve its aims. [1]

When the Fed increases or decreases the target funds rate by specific points, it’s actually establishing a range of rates. Banks and similar institutions then target this range when they lend overnight money to one another. They use these hyper-short-term loans to collectively maintain their required cash reserves or raise immediate operational cash. 

Keeping Time With the Fed

Think of the banking system as an intricate timepiece. Each bank operates independently. Each can choose when or if to lend to or borrow from other banks within the Fed’s current target rate range. Each also sets its own public-facing retail rates. When banks stay in synch with one another and the Fed, the economy will hopefully keep good time. But if even a few cogs get jammed, it can stymie the entire operation. 

In our analogy, the Fed plays the role of a master timekeeper. Or at least it tries to. 

When the Fed increases the target funds rate: It hopes to reduce the flow of excess cash or stimulus in the economy, which in turn can help temper inflation. 

When the Fed lowers the target funds rate: It hopes to keep stimulating cash flowing through the economy … without letting inflation get out of hand. 

Along with adjusting the target funds rate: The Fed also can inject or extract cash into or out of the system in an effort to quicken or slow the wheels of commerce, increase or decrease inflation, ward off a recession, tamp down “irrational exuberance,” and/or otherwise spur or check economic activities. [2]

However, we must emphasize: No single entity can just flip a switch to power the economy off and on. The Fed is in a relatively strong position to encourage long-term economic growth through its actions. Its actions will often trickle down to other types of loans and move them in a similar direction for the same purpose. But not always, and rarely across the board. As in any complex system, any given move interacts with countless others, with varied results. This is especially so globally, as most countries have central banks and “timekeepers” of their own. 

Which brings us to our next point.

The Fed Rate Isn’t Every Rate

To review, the Fed’s target funds rate is the rate range at which banks lend each other overnight cash. Rising rates are meant to help unwind earlier stimulus programs, and manage rising inflation by tinkering with the cash flow in our banking systems. But as an admittedly blunt tool, there is an even more tenuous connection between the Fed’s rates and the interest rates you personally pay or receive. 

For example, fixed-rate debt such as home and student loans may not be immediately affected by rising rates, while free-floating credit card debt is more likely to creep quickly upward in tandem with the Fed’s rates. It’s generally wise to avoid credit card debt to begin with, given their persistently higher rates. It’s even more critical when rates rise.

Similarly, you may or may not receive higher rates on interest-bearing instruments such as bonds, CDs, bank accounts, etc. That’s because it’s the banks and similar entities, not the Fed, who set these rates. 

Part 2: Understanding Inflation

How Do We Measure Inflation? 

Inflation is the rate at which money loses its purchasing power over time. As you might guess, many ways to measure such a squishy figure exist. Various economic sectors, such as energy, food, housing, and healthcare, can complicate the equation by exhibiting wildly different inflation rates at different times. There is an ongoing debate over which figures are most relevant under what conditions. But what should we make of that information? As usual, it helps to consider current events in historical context to discover informative insights.

Inflationary Times: Past and Present

Unless you’re at least in your 60s, you’ve probably never experienced steep inflation in your lifetime—at least not in the U.S., where the last time inflation was as high (and higher) was in the early 1980s. After years of high inflation that began in the late 1960s and peaked at a feverish 14.8% in 1980, Americans were literally marching in the streets over the price of groceries, waving protest signs such as, “50¢ worth of chuck shouldn’t cost us a buck.” [3, 4]

During his 1979–1987 tenure, Federal Reserve chair Paul Volcker is credited with routing the runaway inflation by ratcheting up the Federal target funds rate to a peak of 20% by 1980. (Compare that to the recent increase to 0.05%, as discussed in our last piece.) Aiming to reduce the feverish spending and lending that had become the status quo, Volcker’s strategies apparently affected a cure or at least contributed to one. By 1983, inflation had dropped considerably closer to its cooler target rate of 2%, around which it has mostly hovered ever since. Until now. [5, 6]

The Inflationary Past Is Not Always Prelude

Why not just ratchet up the Fed’s target rates as Volcker did? Unfortunately, it’s not that simple. 

First, as described in this commentary, “Should We Be Scared of Inflation?” there are several broad categories—such as supply and demand, rising labor and production costs, and a nation’s monetary policies—each of which can contribute to inflation individually or in combination. This means each inflationary period is borne of unique circumstances. So, even if a “treatment” seems relatively reliable, you never know for sure how each “patient,” or economy, will respond. [7]

Second, even if an inflation-busting action does work, it’s not unlike treating cancer through aggressive chemotherapy. Left unchecked, the side effects can be worse than the disease. 

Volcker’s actions are a case in point. The higher target rates not only tamed inflation, but they also weakened the economy significantly, leading to an early 1980s “double dip” recession and high unemployment. Overall unemployment hovered above 7% for several years, with some sectors, such as the construction and automotive industries, experiencing double-digit figures. Even if the outcome was worth the pain involved, it’s not a course one embraces enthusiastically. [8]

Investing in Inflationary Times 

We choose judicious optimism over paralyzing fear. Even if the odds are heavily stacked in favor of our taming inflation over time, this is not to suggest it will be easy. And even if we “win” in the end, it’s unlikely it will be obvious until we are able to look back at the events in hindsight. As such, as we press forward, you may repeatedly question what these influences mean today to you and your investments. 

Part 3: Investing in Uncertain Times

After taking a closer look at interest rates and inflation, we come to the heart of the matter: 

When interest rates, inflation, or both are on the rise, what’s an investor to do?

Big picture, we continue to deploy the same core principles to help people invest across time and through various market conditions. These include:

  • Building and maintaining personalized investment portfolios of stocks, bonds, select alternative investments, and cash reserves
  • Minimizing exposure to concentrated investment risks through global diversification 
  • Reducing the impulse to act on fear, excitement, and similar reactions to unfolding news 
  • Keeping an eye on tax ramifications and other costs 

If anything, adhering to these timeless tenets becomes even more important during increased geopolitical uncertainty and economic stress—to guide you past any bouts of doubt.

Future Uncertainty

With so much going on, there’s been no lack of analyses of what to expect across various markets and what investment actions you should take based on these forecasts. 

The trouble is, it’s as devilishly difficult as ever to predict the future. Moreover, those best positioned to offer the most informed insights about the future may be the voices you’re least likely to hear. Wharton Professor Phil Tetlock has dedicated much of his career to studying the efficacy of expert forecasters, and his research suggests as follows: 

“People who generate better sound bites generate better media ratings, and that is what gets people promoted in the media business. So there is a bit of a perverse inverse relationship between having the skills that go into being a good forecaster and having the skills that go into being an effective media presence.” [9]

Historic Insights

If we look to the past, we can find ample evidence of just how hard it is to anticipate various markets’ reactions to current events. Following are some relevant examples: 

Global investing and inflation: In their 2021 analysis, “US Inflation and Global Asset Returns,” Wei Dai and Mamdouh Medhat of Dimensional Fund Advisors studied how bonds, stocks, industry portfolios, factor premiums, commodities, and REITs performed during periods of high and low U.S. inflation from 1927–2020. They found that “most assets had positive average real returns in both low- and high-inflation years.” [10]

Bond investing and interest rates: In “All Eyes on the Fed?” Dimensional Fund Advisors also examined whether Federal target funds rate changes have influenced either global government bond returns or longer- vs. shorter-duration bond returns. They concluded: “Our analysis of global government bond data from 1984–2021 shows no reliable relation between past changes in the federal funds rate and either future bond excess return over cash or future term premiums.” [11]

Bond investing and interest rates (again): You may recall, interest rates did tick upward in 2017–2018, creating concerns similar to those we’re hearing today. At the time, financial author Larry Swedroe published an piece, “Rising Rates Increase Worries,” in which he illustrated why it’s best to disregard breaking news about rising rates (emphasis ours): 

“As in 2018, we entered 2017 with the market anticipating several increases in the federal funds rate. … Despite that, the Vanguard Long-Term Treasury Index ETF (VGLT) returned 8.6% in 2017, outperforming the Vanguard Intermediate-Term Treasury Index ETF (VGIT), which returned 1.7% and the Vanguard Short-Term Treasury Index ETF (VGSH), which returned 0.0%. Investors scared off by the likelihood of rising rates suffered for betting against the collective wisdom of the market.” [12]

Factor investing and economic cycles: One of our timeless investment strategies is to allocate our portfolios across various market “factors,” or sources of expected return, in pursuit of particular long-term outcomes. In an Alpha Architect guest post, “Factor Investing Premiums and the Economic Cycle,” Swedroe also examined whether it had made good historical sense to shift those allocations in response to economic cycles. Bottom line, it had not. Compiling the findings from a number of academic studies, he concludes: “Although a factor’s return changes throughout the business cycle, the ability to predict economic regimes and alter factor allocations accordingly produces less successful results despite being intuitively pleasing.” [13]

Global investing and geopolitics: In his recent work, “Chaos is a friend of mine,” financial columnist Bob Seawright points to a range of historical events demonstrating why complex adaptive systems like financial markets are essentially unpredictable. That’s thanks in large part to chaos theory (aka, “the butterfly effect”): 

“Financial markets exhibit the kinds of behaviors that might be predicted by chaos theory … [E]ven tiny differences in initial conditions or infinitesimal changes to current, seemingly stable conditions, can result in monumentally different outcomes.” [14]

In other words, news from the front lines may seem tremendous or trivial, awful or inspiring, or even everything at once. But avoid letting any of it heavily influence your actionable investment insights; the world is just too chaotic for that. 

Layers of Protection

By now, we hope we’ve described what NOT to do in response to current events: Across stock and bond assets alike, it remains as ill-advised as ever to chase or flee individual positions, markets, or economic cycles. 

If your investment portfolio is already well-structured, you should already be well-positioned to capture appropriate measures of expected investment premiums over time, while defending against inflation and other risk/reward tradeoffs. It may not feel like it right now, while we’re enduring the rising risks. And unfortunately, even a best-laid plan doesn’t guarantee success. But if you weigh the odds, your best course by far is probably the one you already have. 

At the same time, it’s worth reviewing what you are seeking to achieve as an investor, by deploying two broad strategies for protecting against inflation:

Hedging against inflation: To preserve the spending power of upcoming cash flows out of your portfolio (such as in retirement), you can hedge some of your assets against rising inflation. 

For example, you can allocate more of your fixed income to assets that tend to move in tandem with inflation, such as Treasury Inflation-Protected Securities (TIPS) versus “regular” Treasury bonds. Neither is ideal across all conditions. But if you hold some of both, they can complement each other over time and across various inflationary rates. 

We do not suggest piling into assets that may be periodically inflation-sensitive but also exhibit heightened volatility—such as energy stocks, gold, and other commodities. 

Outperforming inflation: At the same time, your longer-term financial goals typically require a portion of your portfolio to outperform inflation over the long haul. For that, you need to stay invested in various markets. As Dimensional’s Dai and Medhat concluded in a recent report, “Overall, outpacing inflation over the long term has been the rule rather than the exception among the assets we study.” [15]

  • Stocks: Equities in general, and especially stock factors such as the value premium, have handily outpaced inflation over time. [16]
  • Bonds: Investing in bonds that offer the highest yield for the least amount of term, credit, and call risk is also expected to help a portfolio stay ahead of inflation over time. (A timely tip: As in any other market, avoid trying to time the bond market in response to breaking news.) [17]
  • Alternative investments: As costs and complexities are coming down among certain alternative investment solutions, you may consider allocating a modest portion of your portfolio to alternative markets such as reinsurance or alternative lending; this may help lower your portfolio’s overall volatility without sacrificing expected returns. [18]

Most investors require elements of both hedging and outperforming inflation, calling for portfolios that are constructed accordingly. Additional defenses against inflation can include: (1) using relatively realistic inflation estimates in your financial and retirement planning; and (2) delaying taking Social Security when possible, to maximize the power of the COLA (cost of living adjustments) on higher monthly payments. 

United We Stand

We’ve thrown a lot at you in a short space, so please consider this material as more of a conversation starter than a comprehensive guide. Most importantly, the decisions you make moving forward should be grounded in your own circumstances rather than general rules of thumb. For that, the best way to move forward is together. Please be in touch if we can assist. 




The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

This material was prepared by Wendy J. Cook Communications, and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate and is intended merely for educational purposes, not as advice.

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