Rate of inflation. Investors should always factor the current rate of inflation into their expected returns. In March, the Consumer Price Index (CPI), which measures the average change in prices of goods and services over time, rose 0.5 percent. Over the past year, the CPI has risen 2.7 percent. John Diehl, senior vice president in the retirement division of The Hartford, says fixed-income investors in particular have to make sure they are earning enough yield in their funds so their returns aren't eaten up by inflation.
Interest rates. The rate of inflation and interest rates have an important relationship. The Federal Reserve monitors inflation closely. "If the Fed observes increased economic activity, then it's only a matter of time until they begin to fear inflation, and they will begin to feel pressure to increase interest rates," Diehl says. The Fed controls the Fed funds rate—or the interest rate at which banks lend to each other. It's been set at virtually zero for more than two years, and that's why many money market funds or savings accounts are yielding only pennies on the dollar.
When the Fed raises rates, it can mean trouble for some bond funds. "Although a progressing economy sounds like a good thing, for bond holders it usually isn't," Diehl says. No one can predict when the Fed will raise rates, but when it does, the value of existing bonds falls, which can lead to losses for certain types of bond funds. Investors should be aware of the duration (a measure of interest-rate sensitivity) of their portfolios so they are well-prepared when interest rates begin to rise again.