MONEY inflation

What Today’s Inflation Report Means for Fed Rate Hikes

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Getty Images—(c) Brand New Images

While slightly improved, inflation remains below the Fed's target. What does that mean for interest rates?

U.S. consumer prices rebounded slightly from last month’s precipitous drop-off, while prices were flat over the past 12 months.

The Consumer Price Index increased 0.2% last month as oil stopped its dramatic fall, and was unchanged compared to this time last year, according the the Labor Department. So-called core inflation, which strips out volatile energy and food prices, rose by 1.7%, still well below the Federal Reserve’s 2% target.

Prices had fallen the three previous months.

While firmer than previous months, these low inflation rates come at a critical time for the Federal Reserve.

Investors have received mixed messages from central bank officials and economic data recently. For months, the Fed had reassured Wall Street that it would be patient when it comes to removing its accommodative monetary policy. Last week, though, the Fed dropped the word “patient” from its statement, implying that interest rates could rise soon—perhaps as early as June.

Yet in the same breath, the Fed lowered its growth and inflation expectations in the near term and signaled that even if rates are lifted soon, they won’t climb as rapidly as previously thought. That caused the stock market to soar.

“Just because we removed the word ‘patient’ from the statement doesn’t mean we are going to be impatient,” Yellen said in a press conference after the statement was released. “Moreover, even after the initial increase in the target funds rate, our policy is likely to remain highly accommodative to support continued progress toward our objectives of maximum employment and 2% inflation.”

Fed Vice Chair Stanley Fischer said yesterday that rates would likely rise this year. The federal funds rate, Fischer said, will be determined by economic conditions, rather than by a predictable path.

Competing economic indicators and measurements are complicating the Fed’s dual-mandate of price stability and maximum employment. Employers hired nearly 300,000 workers last month, and the unemployment rate dipped to a post-recession low of 5.5%.

Yet wages aren’t growing strongly and the strong dollar, while a boon for U.S. tourists traveling abroad, has made U.S. exporters less competitive globally. Low oil prices save hundreds, if not thousands, of dollars for drivers annually, but have weighed heavily on the bottom line of energy companies.

The Fed seems to be inclined to raise rates given the improving labor market, but has been hamstrung by a lack of meaningful inflation and consistent wage acceleration. By increasing the cost of borrowing, the Fed runs the risk of slowing down economic activity in the midst of a burgeoning recovery. Will interest rates really rise before economists can see the whites of inflation’s eyes?

MONEY interest rates

Higher Interest Rates Are Coming. Here’s Who Wins and Who Loses

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Getty Images

The Fed says rate hikes will be gradual, but they'll affect everything in the economy, from your mortgage to your job to your 401(k).

Federal Reserve chair Janet Yellen has signaled, by omitting the word “patient” from her latest statement, that the central bank could begin raising interest rates as early as this summer. On Monday, Stanley Fischer also suggested in a speech that rate hikes are likely before the end of the year.

The rise is likely to be slow and bumpy. Still, the Federal Reserve’s benchmark short-term interest rate has been near zero since the financial crisis in 2008, and it’s been a long time since investors, borrowers and consumers have dealt with a rising-rate environment. The Fed’s decision to move rates in the other direction, when it comes, is something you’re sure to feel in your wallet.

So here’s a primer on who is helped and who is hurt when the Fed makes borrowing more expensive.

Helped: Anyone looking a safe place to stash money

Savings and money market accounts today offer an average interest rate of only 0.44%, according to Bankrate, but the good news for savers is that rising interest rates should buoy yields across the board. One caution is that if the Fed moves slowly, that means the interest earned on your accounts probably won’t bump up very quickly either. So if saving more this year is a big priority for you, take matters into your own hands with these moves, geared toward powering up your savings.

Hurt: New borrowers, and anyone with an adjustable loan

Rising interest rates push up borrowing costs for home and auto loans. If you already locked in a 30-year mortgage at the ultra-low rates that have prevailed over the past several years, you were probably smart. According to Freddie Mac, 30-year mortgage rates are 3.7% on average today, compared with nearly 6% a decade ago.

But the millions of Americans who hold adjustable-rate mortgages could end up paying more. Mortgages are typically pegged to the 10-year Treasury bill. While the Federal Reserve doesn’t control this rate directly, long-term rates typically rise in response to the short-term rates the central bank sets. The good news? Since Treasuries are a safe haven for global investors, yields are generally being held down by high demand—which rises every time there’s bad news in, for example, Europe. So mortgage rates might rise comparatively slowly even after the Fed takes action.

Not so clear: Anyone looking for a job or a raise

One of the Federal Reserve’s mandates is is to maintain full employment. When unemployment rises, it can try to stimulate growth by cutting rates. The idea is that cheaper borrowing makes it easier for consumers to spend and for businesses to expand and hire new workers. The flipside is that higher interest rates and tighter money supply can make hiring less likely. That’s one of the reasons the Fed has been so hesitant to raise rates in recent years, and there’s a risk that a too-early rate hike will cut off job growth.

Of course, keeping interest rates low for too long can come with its own danger: inflation. If there’s no “slack” left in the labor market—meaning that basically everyone who wants to work and can work already has a job—the easy availability of money will stop creating jobs and instead show up in the economy as higher prices. Ideally, the Fed would wait to raise rates until the precise moment when employment tops out and before inflation takes off. But where exactly that point is can be a contentious issue. At the moment inflation is very low and wages have yet to take off (suggesting some slack is left.) But a series of strong jobs reports seems to have some on the Fed wanting to get ahead of the curve.

Hurt: Owners of bonds and bond funds

You likely have a portion of your money, in a retirement portfolio such as a 401(k), invested in bonds.

Rising interest rates mean falling bond prices. Bonds typically pay a fixed coupon, so when prevailing rates rise, the value of your bond portfolio falls until its yield matches what’s available elsewhere on the market. The size of your losses depend on how steeply rates rise and the maturity, yield and other characteristics of the bonds you own. Wall Street sums up a bond’s interest rate sensitive with a figure called duration. You can look a bond fund’s average portfolio duration at sites like Morningstar. In general, duration tells you how large a capital loss you can expect for each 1% increase in rates. So Vanguard Total Bond Fund, with an average duration of 5.6, would fall about 5.6% with a 1% increase in rates.

There’s good news though: If you own a bond fund, the decline in your fund’s value will be made up with higher payouts as your fund acquires new bonds with higher yields. You’re likely to be made whole in a few years. Future bond investors benefit, too.

Not so clear: Stock investors

Whether rising interest rates will help or hurt U.S. stocks is a more complicated question.

All else being equal, a hike should hurt. One big reason is many investors choose whether to put money into either stocks or bonds, as bond yields pay more stocks become comparatively less attractive. But there are lots of other things to consider. For instance, stocks typically reflect investors’ attitudes about the overall health of the economy. And the if the Fed is signaling that it might raise rates, then it also thinks the economy is healthy enough to handle it. Other investors might view this as a bullish signal.

What does history say? The record is mixed. Stock researcher S&P Capital IQ recently examined 16 previous rate tightening cycles since World War II and found that the Fed’s moves led to stock market declines of 5% or more about four-fifths of the time. However, a separate study by T. Rowe Price looked at the question slightly differently: T. Rowe examined nine instances since 1954 that the Fed has raised rates following a recession. It found an average market gain of 14% a year later. In other words, it’s hard to know exactly how the market will react—except to say that it could be bumpy ride.

Helped: Banks

Banks make money by borrowing at low short-term interest rates (think checking and savings deposits) and lending it out at higher, longer-term rates. In an ideal world, they’d love short-term rates to remain at rock bottom, as long as longer term rates are high too. So you might not think they’d be cheering for a short-term interest rate increase.

Their problem has been that long-term rates aren’t high, but low. Meanwhile short-term interest rates can’t really go below the zero they’re stuck at. That’s left them little room in the middle. A rate hike will could give banks a window of opportunity to earn more attractive “spreads” once the Fed moves.

Helped: Anyone looking to spend U.S. dollars abroad

When interest rates rise, it pushes the value of U.S. currency up. That’s good for American consumers who want to buy foreign goods (and go on European vacations) cheaply.

Hurt: Anyone looking to sell things to foreigners.

But there are dangers in a too-strong dollar. If our currency is too strong, it means it willll be harder to sell U.S.-made products globally—which would be bad for economic growth.

Not so clear: Foreign stock funds

Most international-stock mutual funds hold assets denominated in other currencies, like the euro. The strong dollar means those assets they are worth less, all else being equal. (Some funds “hedge” their currency exposure.)

Over the past year, the MSCI All-Cap World EX-USA index is up 14.6% in local currency terms through Feb. 28. But according to Morningstar, the average foreign stock mutual fund—with roughly half its assets in Europe —has falled 0.06%.

On the other hand, the a strong buck isn’t all bad for foreign stocks. Companies in countries with weaker currencies will be able to export more goods to the U.S, boosting their earnings. And while it’s no fun to see your market winning vanish, investors are usually better off riding out such currency swings. When the dollar next weakens, your foreign stocks will have a tail wind.

One special case is emerging markets stocks. Razor-thin U.S. interest rates have been a boon for them, as U.S. investors, frustrated by dismal yields at home, have shifted money abroad. Once that changes, much of that money could rush back home.

MONEY inflation

Why You Should Hate Low Inflation

two balloons tied to one another
Robert Warren—Getty Images

The Federal Reserve hates near-deflation inflation too. Which is why the Fed hinted that the pace of interest rate hikes will be more gradual than expected.

You may think that you like abnormally low, bottom-of-the-barrel, near-non-existent inflation, but you don’t. Or at least you shouldn’t.

The first thing you have to understand is that inflation—or the general rise in the price of basic goods and services—has been historically low since the financial crisis. Some folks may have a tough time believing that, since the cost of some goods like meat and education, seem to only increase.

Nevertheless, over the last 24 months overall consumer prices have rested at or well below the Federal Reserve’s 2% target. Last month inflation dropped on a year-over-year basis thanks to very cheap oil. If you strip out volatile food and energy prices, inflation only rose at a rate of 1.6%.

So inflation is low. But why is that bad, exactly? Isn’t it a good thing for consumers that prices in general are growing only slightly? Who wants to pay more for things?

In a word: wages. There has been no sustained accelerated income growth for American workers since the Great Recession.

Despite an unprecedented fiscal stimulus effort, despite years of near-zero interest rates, despite three massive rounds of unconventional bond buying to lower long-term interest rates that many economists and politicians wrongly predicted would cause soaring prices, despite a year in which the economy has been adding 200,000 or more jobs a month, there just hasn’t been any meaningful wage growth.

A good metric that illustrates this point is the “employment cost index,” which measures fringe benefits and bonuses in addition to wages. In the last three months of 2014, total compensation grew at rate of 2.3%, or about a full percentage point lower than before the recession. If you look at median hourly wages, you see a similar picture. Workers just haven’t seen meaningful raises in a long time.

fredgraph (2)

This has a harmful effect on the economy. My spending is your income, so if I don’t see more money in my paycheck, chances are neither will you.

The Federal Reserve is clearly concerned about this problem.

The central bank’s most recent economic projections lowered the outlook for core inflation and economic growth in 2015, while simultaneously predicting that the unemployment rate will decline as well.

Which means that the labor market has some more to tighten.

And these worrisome economic indicators are allowing the Fed to be extra cautious about raising rates. “The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run,” the Federal Open Market Committee said in a statement.

If we are in a prolonged period of low-growth, as economists like Paul Krugman and Larry Summers have written, then the Fed should wait until the threat of inflation becomes real before pulling away the punchbowl.

Of course there is a real fear that if you let inflation run, it could quickly get out of hands. Inflation soared by more than 14% in the spring of 1980, while unemployment ran high and the economy ping-ponged between recessions. Then-Fed Chair Paul Volcker dramatically hiked interest rates to tame inflation, which pushed the U.S. into another painful recession just as Janet Yellen was beginning her career as an economist.

The Fed has certainly not rushed to raise interest rates this time, even when the economy blew past certain benchmarks. But there has been a tone that the time is nigh for an interest rate increase despite the lack of inflation. Rates have been very low for a very long time.

Whether it’s this summer or fall or next year, interest rates will eventually rise. (Although as MONEY’s Pat Regnier points out, they won’t rise as much as fast as the Fed originally thought.)

When they do, you should hope that inflation has moved much closer to, or even slightly beyond, the 2% target. The quality of your paycheck may depend on it.

MONEY Economy

Why This Fed Meeting Could Be a Game Changer

dollar sitting on fan of Euros
Dado Ruvic—Reuters

On Wednesday, the Fed may hint at raising interest rates for the first time in almost a decade. These three major issues will affect their decision.

Employment is up and economic growth is stronger, but that hasn’t made Janet Yellen’s job any easier. The Federal Reserve chair now has to decide how she’ll shift monetary policy out of crisis mode—the Fed has kept short-term interest rates near zero since 2008—and into something more like normal. All without breaking anything in the process.

That problem is the backdrop to the Federal Reserve’s Open Market Committee meeting on Tuesday and Wednesday. If early predictions are correct, the big news from the meeting may be that Yellen removes her pledge to be “patient” about possible interest rate hikes. If so, based on what Yellen has said about how she’ll signal a coming policy shift, the Fed could start raising its benchmark interest rate as early as June. That would ripple through the economy as lenders raise their own interest rates on loans.

But even before the Fed actually raises rates, any hint that it could raise rates will itself have an effect on markets, as investors and businesses try to get ahead of the trend.

In making this decision, the Fed faces three tough questions:

  • We have stronger economy—but is it strong enough to withstand higher rates? By many measures, the U.S. economy is doing quite well. Job growth has topped 200,000 per month for 13 straight months, and the unemployment rate has now fallen to 5.5%—four and a half points lower than at the height of the financial crisis. Yellen has previously promised to keep interest rates low until unemployment improved. Will she finally decide her job is done?
  • Does the rallying dollar change the game?. While a strong economy might make Yellen more comfortable about raising rates, an increasingly valuable dollar might push her in the opposite direction. America’s (relative) prosperity combined with Europe’s stagnation—and now looser money from the European Central Bank—has caused the euro to crash in value against the greenback. The EU’s currency recently fell to a 12-year low versus the dollar, making U.S. exports more expensive and potentially hampering future growth. Will the Fed decide to keep interest rates low for longer in the hopes of keeping the dollar competitive with the euro, or will the desire to normalize monetary policy win out?
  • Where’s the inflation? The reason to raise rates is to prevent a hot economy from igniting higher inflation. It might seem silly to worry about inflation when the dollar is the strongest it’s been in years and wage growth is all but nonexistent. That’s what economists like Paul Krugman and Lawrence Summers are arguing. On the other hand, lower unemployment suggests wages could rise in the near future, eventually pushing up prices. Although there is very little inflation right now, so-called inflation “hawks,” including some Federal Reserve regional bank presidents and members of the Fed’s rate-setting committee, think the central bank should act early to nip it in the bud.

We’ll know more about how the Fed is answering these questions on Wednesday, when the Fed announces it rate decision. Until then, “patience.”

MONEY inflation

3 Signs Inflation May Be Lurking Just Around the Corner

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Kutay Tanir—Getty Images

While consumer prices haven't been rising yet, several signs point to higher wages in the future. Here's what you should do.

After fits and starts and ups and downs, the American economy is finally looking strong — especially compared to Europe. U.S. gross domestic product grew 2.2% and 5% in the last two quarters of 2014, while the unemployment rate dropped in February to 5.5.%.

Yet inflation and wage growth, which are natural outgrowths of an accelerating economy, haven’t seemed to materialize.

At least not yet.

Despite years of unconventional bond buying and warnings from politicians and economists, consumer prices have actually risen less than the desired rate of the Federal Reserve.

The Consumer Price Index declined 0.7% in January, the steepest drop since 2008, thanks to cheap oil. If you strip out volatile energy and food prices, so-called core inflation only rose 1.6% in January over the past year, well below the Fed’s 2% target.

In fact, prices haven’t hit that Fed target in almost two years. Your paycheck has hardly fared any better.

But lately, there have been signs that show America’s workforce might at long last receive an overdue raise. About 70% of companies have said that wages are beginning to outpace inflation, according to the latest Duke University/CFO Magazine Global Business Outlook Survey. Industries like technology, manufacturing and health care should see wages grow by 3%.

A small business report points to a tighter labor force, as 26% of companies raised compensation (although that includes benefits like health care), and almost half said finding a qualified employee proved difficult.

What’s more, the 10-year break-even inflation rate, which is a gauge of how much prices are expected to rise annually over the next decade based in part on the yield of 10-year Treasury inflation protected securities — has been ticking up lately to about 1.8%, after touching a recent floor of 1.5% in the beginning of the year. The rate, to be fair, is still well below levels seen before oil’s drop.

So is inflation and wage growth finally set to take off?

That’s a question for Federal Reserve Chair Janet Yellen, who has said the Fed will remain “patient” when raising short term interest rates while price growth remains so benign.

This six-year herky-jerky recovery has made fools of many prognosticators, especially those who have shouted loudly that inflation is nigh. “Given that CFOs expect continued strong employment growth, it is surprising that wage pressures are not even great,” says Duke finance professor John Graham. Indeed.

What does this mean for your portfolio?

Well, one option is to add to your Treasury Inflation-Protection Securities (TIPS) holdings, especially short-term TIPS if you’re a conservative investor (though this should still be only a satellite portion of your investments).

TIPS have struggled recently after outperforming equities by 11 percentage points in 2011, and investors have started to put their money elsewhere.

But the best time to get inflation protection is when there’s little fear of rising consumer prices — and when inflation-protected bonds are cheap, like now. For instance, the Vanguard Target Retirement 2015 fund currently allocates about 8% of its portfolio to short-term inflation protection.

TIME Venezuela

Venezuela Is Slowly Coming Apart—and President Nicolas Maduro May Pay the Price

A boy with blood on his chest kneels in front of police after 14-year-old student Kluiver Roa died during a protest in San Cristobal, Venezuela, Feb. 24, 2015.
Carlos Eduardo Ramirez—Reuters A boy with blood on his chest kneels in front of police after 14-year-old student Kluiver Roa died during a protest in San Cristobal, Venezuela, Feb. 24, 2015.

Hyperinflation and shortages of basic goods have Venezuelans angry—and looking for new leadership

CARACAS – Amid the death of a 14-year-old boy killed by a policeman during anti-government unrest, the arrest of a key opposition mayor by armed government intelligence agents and talk of a coup plot against the government spearheaded by Washington, this last week also saw another another turn in Venezuela’s growing crisis. At DolarToday, a website little known outside of Venezuela that has become a key indicator of the country’s black market exchange rate, the bolívar local currency passed the psychological barrier of 200 per greenback. Four years ago, the dollar cost eight bolívares per dollar; five months ago it was 100; now it is already at 221 and counting. This rapid deterioration in the value of the local currency, 61% drop against the dollar over the last year, is one of the best indicators of just how much trouble Venezuela—and President Nicolas Maduro—is in.

While many in Venezuela have little direct engagement with the dollar—the country’s foreign exchange is strictly controlled—the currency crisis pervades everyday life. It means many doctors and engineers earn the equivalent of just a dollar a day and prefer instead to drive taxis or smuggle pasta or gas across the border to Colombia. It means that those who want to buy basic goods for their families must line up for hours every day due to shortages, and hoping all the time that shelves won’t be empty. It means that stealing is more valuable than working, fueling one of the world’s highest crime rates and the murder of one police officer nearly every day.

It means that people like Yormina Alguilera, a street cleaner earning the same as the minimum wage of doctor or engineer, are giving up. “We’re in crisis,” she said, taking a break from the sun at a fruit stall in the square at Caracas’ 23 de enero barrio, as murals of Che Guevara and Hugo Chávez loom over. Alguilera voted for Maduro and his predecessor Chávez, “but never again,” she said. “At least under Chávez I could get things. It’s a mess with Maduro and there’s no end in sight. Things are getting worse every day.”

Maduro, who was elected after the death of Chávez in 2013, is in serious trouble. His approval ratings are in the low twenties, according to Datanálisis, a respected local pollster. This time last year, the president faced down Venezuela’s biggest anti-government protests in more than a decade, and now they appear to be starting up again. In San Cristóbal, on the country’s border with Colombia and where unrest was sparked last February by similar though less severe economic problems, 14-year-old Kluiberth Roa was killed with a rubber bullet by police. That tragedy has only sparked further public anger.

Supermarket lines often run into the hundreds if not thousands due to shortages of the most basic goods, from shampoo to condoms. Inflation last year was near 70%. The economy, which has long been propped up by high crude prices, is crumbling as oil has tumbled over the last few months. (A barrel of Venezuela oil sells for half what it did a year ago; the country obtains 96% of foreign currency from oil.) Maduro has blamed this on an “economic war” being waged by the opposition with a hand from the United States, but many ordinary Venezuelans don’t believe that. “They talk about an economic war but we’re certainly not winning it,” said Aida Guedez Álvarez, a 61-year-old housewife buying a watermelon in 23 de enero. “I voted for Maduro but I’ve been deceived, like everybody else.”

Maduro’s government faces tough legislative elections later this year. “The government isn’t necessarily falling but it is weak and losing its leadership,” said Reinaldo Manrique, 24, an accounting student and student leader who was one of the very first detained for protesting in San Cristóbal, last year, sparking nationwide unrest. “But you know what? The leaders of the opposition are even more weak.”

Though former Chavistas are much angrier than they were a year ago, they do not see the opposition, led loosely by two-time presidential candidate Henrique Capriles, as a viable alternative. “Of course I’d never vote for Capriles,” said Alguilera, the street cleaner. “I give up. No one will change things.” Rather than protest, students are talking of finishing their studies and leaving the country. Many who took to the streets last year have left. “I’m studying to become a primary teacher,” said Leonardo Díaz, 25, in Caracas’ Plaza Altamira, a bastion of protest. “But as soon as I graduate, I’ll leave. All my friends at university are the same.”

Capriles, who stood against both Chávez and Maduro in presidential elections, is the more moderate face of the opposition. He continues to govern the state of Miranda and at least on paper lead the opposition. The government has cracked down on its more hardline critics. Leopoldo López, a major opposition heavyweight, has remained behind bars for more than a year for his role in inciting last year’s protests. “The government is working in a barbaric way to steal from public funds, destroy the country, rob the country’s oil while it says it’s constructing a homeland!” López’s father, also called Leopoldo, told TIME. Antonio Ledezma, Caracas’ mayor, was arrested and charged earlier this month in a conspiracy to overthrow Maduro.

María Corina Machado, another more radical leader, was charged in December with involvement in a plot to assassinate Maduro. “With Maduro there is more persecution than ever,” she told TIME. Next on the government’s list appears to be Julio Borges, an opposition party coordinator. The government requested a probe into his alleged conspiracies against Maduro this week. “Every year there are elections but this is the first time the government is up with a political crisis of this magnitude,” Borges told TIME. “In Venezuela everyone is scared—including the government.”

Maduro has remained tough. “Every fascist has his day,” the president said on Ledezma’s arrest. And he still has some support. As he completed a crossword on a park bench in the wealthy La Castellana area of Caracas, Emilio Neumann backed the government’s stance. “Lopez and Ledezma are exactly where they deserve to be, behind bars,” said the 69-year-old public administrator. “After calling so many people to the streets and committing who knows how many murders.”

President Maduro must hope, if he is to see out the next couple of years, that he can persuade people like Neumann to stay on side. To do this he must turn the country’s economy around, though with three official exchange rates as well as a black market on the dollar — with a spread between the highest and lowest of them of some 3,400 per cent — it is becoming increasingly difficult to do so. Pragmatic moves such as consolidating those exchange rates or raising the price of gas, currently the world’s lowest at just a few cents per tank, are politically dangerous especially when Chavistas are turning away from Maduro.

MONEY retirement planning

The Proven Way to Retire Richer

Looking for more money for your retirement? Who isn't? This study reveals that there is one sure-fire way to get it.

Last June, the National Bureau of Economic Research with professors from the University of Pennsylvania, George Washington University, and North Carolina State University, released a study entitled “Financial Knowledge and 401(k) Investment Performance”.

In it the authors found that individuals who had the most financial knowledge — as measured through five questions about personal finance principles — had investment returns that were on average 1.3% higher annually — 9.5% versus 8.2% — than those who had the least financial knowledge.

While this difference may not sound consequential, the authors noted that it “is a substantial difference, enhancing the retirement nest egg of the most knowledgeable by 25% over a 30-year work life.”

Yes, knowing the answers to five questions had a direct correlation to having 25% more money when you retire.

So what are those questions? For example, and for the sake of brevity, here are the first three:

Interest Rate: Suppose you had $100 in a savings account and the interest rate was 2% per year. After 5 years, how much do you think you would have in the account if you left the money to grow?

Answers: More than $110, Exactly $110, Less than $110.

Inflation: Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After 1 year, how much would you be able to buy with the money in this account?

Answers: More than today, Exactly the same, Less than today.

Risk: Is this statement True or False? Buying a single company’s stock usually provides a safer return than a stock mutual fund.

While the questions aren’t complex, they’re tough. And few people can answer all three correctly (with the answers being: More than $110, Less Than Today, and False).

So what did those people who were able to answer those questions most accurately actually do to generate the highest returns? The authors found one of the biggest reasons was that the most financially literate had the greatest propensity to hold stocks (66% of their portfolio was in equity versus 49% for those who scored lowest). And while their portfolios were more volatile, over time, they had the best results.

This is critical because it underscores the utter importance of understanding asset allocation. This measures how much of your retirement savings should be put in stocks relative to bonds. A general guideline is the “Rule of 100,” which suggests your allocation of stocks to bonds should be 100 minus your age. So, a 25-year-old should have 75% of their retirement savings in stocks.

Some have suggested that rule should be revised to the rule of 110 or 120 — and my gut reaction is 110 sounds about right — but you get the general idea.

This vital distinction is important because over the long-term stocks outlandishly outperform bonds. If you’d invested $100 in both stocks and bonds in 1928, your $100 in bonds would be worth roughly $7,000 at the end of 2014. But that $100 investment in stocks would be worth more than 40 times more, at $290,000, as shown below:

Of course, between the end of 2007 and 2008, the stock investment fell from $178,000 to $113,000, whereas the bonds grew from $5,000 to $6,000, displaying why someone who needs the money sooner rather than later should stick to bonds. But a 40-year-old who won’t retire for another 20 (or more) years can weather that storm.

Whether it’s $100 or $1,000,000, watching an investment fall by nearly 40% in value is gut wrenching. But in investing, and in life, patience is key, and as Warren Buffett once said, “The stock market serves as a relocation center at which money is moved from the active to the patient.”

While everyone’s personal circumstances are different (my risk tolerance is vastly greater now than it will be in 30 years) knowing that you can be comfortable allocating a sizable amount of your retirement savings to stocks will yield dramatically better results over time.

MONEY Shopping

Girl Scouts Raise Cookie Prices

Ashley Rubin, 9, holds a sign during Girl Scout Troop 582's cookie training session at Beach Vineyard Church in Panama City Beach, Florida, 2015.
Heather Leiphart—AP Ashley Rubin, 9, holds a sign during Girl Scout Troop 582's cookie training session at Beach Vineyard Church in Panama City Beach, Florida, 2015.

Stocking up on your favorite Thin Mints and Samoas could put a bigger dent in your wallet this year.

Five bucks for a box of Thin Mints? That’s how much Girl Scout cookie fans will pay in some regions of California, up from $4 a year ago. In parts of the South, prices will rise to $4 a box from $3.50.

As cookie-selling season gets under way, Girl Scout councils in San Diego, Orange County, and Greater Los Angeles are hiking prices for the first time in a decade. The increase will bring more money into local scout troops—about 27% more per box by their estimates, the WSJ reports. Each council sets prices in its own region (in the New York area, prices are staying at $4.)

In March, the Girl Scouts announced that they were taking cookie sales online. It also introduced three new flavors for 2015. This latest change is attributed to increased prices charged by the baker (up 19%) and higher operating costs (up 28%), according to a statement from the Greater Los Angeles Council.

Price hike or no, the Girl Scouts say you’re still getting a bargain. At the local rate of inflation, a box of cookies should actually cost $5.84.

MONEY

Fed Holds Rates Steady as Economic Plot Thickens

The Federal Reserve has said it won't raise rates before summer. But the economy picture is no less complex as the date approaches.

The Federal Reserve wrapped up a two-day meeting in Washington Wednesday, leaving short-term interest rates unchanged at near historic lows.

The move was widely expected: The central bank indicated as recently as December that investors weren’t likely to see a rate hike before summer. But the Fed’s actions were being closely watched nonetheless. With the summer deadline now two months closer, recent moves by the European Central Bank to bolster the continent’s economy have complicated the Fed’s upcoming choice.

The upshot is that for now U.S. consumers should be able to rest assured. Ultra-low interest rates mean borrowing costs for mortgages and other loans are unlikely to climb dramatically. But investors won’t have it so easy: Stock and bond traders will continue to fret about U.S. and European officials’ decisions, meaning more volatility like the sharp drop in Treasury yields (and rise in bond values) that took place earlier this month.

The Fed’s last meeting took place in mid-December amid feelings of increasing economic optimism. The U.S. economy had logged 3.9% GDP growth in the third quarter and the November jobs report was one of the best in months. That’s largely continued. Throw in an assist from cheap gas, and it’s no surprise the President Obama felt safe bragging about the ecomony in last week’s State of the Union.

In short, many Americans are beginning to feel like things are normal again. That’s usually the signal for the Federal Reserve to return interest rates to a more regular footing. Raising rates can slow economic growth — that’s why the Fed doesn’t want to move to soon. But keeping them low can stoke inflation. At 1.6%, well below the Fed’s 2% target, that’s not an immediate problem. The worry is that once inflation starts to rise, it can quickly get out of control.

The Fed’s decision is so tough this time around because it took such extraordinary measures to prop up the economy in the wake of the Great Recession. While so far the Fed’s strategy seems to have worked, no one likes being uncharted territory. Fed officials may feel some pressure to return monetary policy to something that feels normal.

One big problem, however, is that even as the U.S. economy has improved, much of the rest of the world continues to lag. Last week struggles in Europe prompted the ECB, Europe’s equivalent of the Fed, to undertake some extraordinary actions of its own, committing to buy tens of billions of dollars in debt each month in a new bid to stimulate the continent’s economy.

With the global economy so intertwined, the Federal Reserve has to worry weakness and instability overseas could put a drag on otherwise healthy U.S. economic expansion. In particular, the ECB’s move, the equivalent of printing billions of Euros, is likely to weaken the common currency against the dollar. That will make it more expensive for U.S. companies to export their goods — ultimately hurting profits and also providing another check on U.S. inflation.

The upshot is that if the Fed was feeling ready to act sooner rather than later, the situation overseas may be giving it second thoughts. Of course, the Fed has given itself until summer to decide. So it’s got some breathing room, if not quite as much as it did in December.

But in the meantime don’t expect jittery traders to sit tight. The Dow dropped 100 points after the Fed’s announcement from 17,452 to 17,319, while Treasury yields fell as bonds rallied. You can expect more of that kind of drama.

MONEY early retirement

Get These 3 Variables Right and Retire Earlier

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Chris Clor/Getty Images

Most people overestimate what they'll need to live comfortably in retirement. The more realistic you are, the sooner you might be able to kick back.

How do you know if you can retire? Despite all the attention given to your retirement “number”—your total savings—there are several other important variables that go into the retirement equation. If you want an accurate estimate for when you could retire, you must choose reasonable values for each one of them. Get these numbers wrong, either too optimistic or too pessimistic, and it could throw off your retirement calculations by years.

In my experience, people tend to be overly pessimistic about their retirement variables. Maybe it’s all the “bad” news about retirement. Or maybe it’s an abundance of caution around this critical life decision. But if you can be realistic about these numbers without being reckless, you can potentially accelerate your retirement and the freedom it brings.

Even if you have a financial adviser, it’s a good idea to become familiar with the key retirement variables yourself. Yes, some math is required, but it’s pretty simple. And there are easy-to-use retirement calculators that can handle the details for you. So let’s take a look at these important retirement parameters.

1. Living expenses. It’s common to assume that your retirement living expenses will be a fixed percent of your pre-retirement income. But if your lifestyle is unique in any way, especially if you’re a diligent saver, these income-based estimates can be wildly inaccurate. The best way to know your expenses is to actually track them yourself. One expert says you can retire on less than 60% of your working income, which is consistent with my personal experience.

And the news about expenses gets better: The typical retirement calculation automatically increases your living expenses every year by the rate of inflation. That sounds reasonable at first glance. Yet research shows that most people’s expenses decline as they age. Studies show decreases from 16% to as much as 40% over the stages of retirement. Even with higher health-care costs, you simply can’t consume as much at 80 as you did at 60.

2. Inflation rate. Inflation remains a critical retirement variable, because it can influence your fixed living expenses and the real returns on your investments. Many fear higher inflation in the future. Pundits have been expecting it for more than a decade. Although conditions might favor higher inflation down the road, nobody knows for sure when or how it will arrive. In my opinion, trying to plan for extreme inflation is not sensible. And many retirees, myself included, experience a personal inflation rate that is below the government’s official rate, proving that you have some control over how inflation impacts your life.

3. Tax rate. Taxes are one of the most feared and loathed factors in retirement. Yet in my experience as a middle-income retiree, taxes aren’t as big a deal as they are made out to be by those with an agenda for your money (or your vote). In the lower tax brackets, income taxes are just another expense, and not a particularly large one. When calculating taxes for retirement, be especially careful to distinguish between effective and marginal tax rates. Your effective tax rate is your total tax divided by your income. Your marginal rate is the amount of tax you pay on your last dollar of income. That’s a function of your tax bracket and is nearly always much higher than your effective rate.

Most retirement calculators use an effective rate, but that isn’t always clear. If you mistakenly enter a marginal rate into a retirement calculator, you will grossly overestimate your tax liability and underestimate your available retirement income. For example, my marginal tax rate in my peak earning years was 28%; now that I’m retired, my effective tax rate has been around 6%. Big difference!

So there is room for optimism on some key retirement variables. But retirement planning is an exercise in reality, and the reality of the stock and bond markets right now is more negative than positive. Investment returns are one retirement variable where you cannot afford to be overly optimistic, or you could run out of money in your later years. Many experts point to current low interest rates and high market valuations as indicators that we must plan for lower returns going forward. How much should you scale back your expectations? That’s anybody’s guess, but I’m seeing estimates of from 2%-4% below the long term averages for stock returns.

Retirement analysis can be difficult and perplexing. A good retirement calculator can condense all the variables into a single view of your financial trajectory. For the most accurate picture, choose realistic values. Don’t lengthen your journey to retirement with excessive assumptions for living expenses, inflation, or tax rates. But don’t get overly confident about investment returns, either. A realistic analysis will increase your odds of working and saving the right amount, before you make the leap to retirement.

Darrow Kirkpatrick is a software engineer and author who lived frugally, invested successfully, and retired in 2011 at age 50. He writes regularly about saving, investing and retiring on his blog CanIRetireYet.com.

Read next: Retirement Calculators Are Wrong But You Need One Anyway

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