Money Matters: Inflation can affect long-term investor plans, progress

By David Peartree The Daily Record Newswire "The Inflation Conundrum" -- that is how a recent Wall Street Journal article aptly framed the current inflation dilemma. Inflation expectations are on the rise, but a surge in inflation is far from a sure thing. Inflation is one of the key indicators to which a long-term investor should pay attention. What are the implications of inflation, why are expectations on the rise, and what should investors watch for and do about it? Inflation operates as a stealth tax on investors. It steals value from investors, especially bond investors. As the rate of inflation increases, expectations for further increases can add momentum to the process. This is particularly damaging for investors in bonds, which are generally a fixed-income asset. A fixed rate of return becomes less valuable when the price of everything else is rising. Also, inflation expectations get baked into the yield demanded by bond investors. In a rising inflation environment, investors will demand a higher rate -- an additional premium on the bond's yield. Bonds issued earlier when rates were lower typically become less valuable, pushing those bond prices down. This is the inverse, or seesaw, relationship between bond yields and prices. Inflation expectations are rising because last year the Federal Reserve said it wanted more inflation, and now we seem to have it. The Fed embarked on a second round of quantitative easing (QE2) because it feared deflation. By adding more liquidity to the banking system, it hoped to boost the stock market and the prices of other assets. This is the "wealth effect" that Ben Bernanke referred to: making people feel more wealthy and willing to spend because they see their asset values rising. Well, the Fed tends to get what it wants, but it doesn't always own up to it. Now that commodity prices have spiked, with a bit of a correction of late, the Fed has said, "who us?" "We aren't to blame for that." But ordinary consumers have seen a steady rise in food and energy prices which comprise what is known as "headline" inflation. These are the prices that consumers see almost daily and which eat up a significant chunk of the typical household budget. Despite the surge in headline inflation, a widespread spike in inflation is far from certain in the near-term. The biggest reason is that rising wages tend to be the major driver of inflation and wages are essentially stagnant. So long as unemployment remains high, it will be difficult for inflation to gain traction. Yes, the economy has been adding jobs, but mostly in sectors where unemployment is high and where hiring is unlikely to drive up wages. Also, price spikes in commodities tend not to get passed on to consumers aggressively when unemployment is high. Consumers tend to react to rising food and energy prices by decreasing spending elsewhere. The feedback from spiking commodity prices can, in fact, be deflationary. Housing prices continue to fall, another deflationary push. Lastly, most of the money the Fed created to fund its latest bond buying binge is reported to sit on bank balance sheets as reserves and is not in circulation. No circulation means no monetary velocity and, for now, no direct, inflationary push from those dollars. A widespread surge in inflation in the near term is far from a sure thing and probably unlikely. Over the long-term, however, all the monetary easing from Quantitative Easing I and II poses a substantial risk if not unwound. How long the near term scenario of subdued inflation will last is the difficult and, probably, unanswerable question. What are the implications for investors? First, avoid a precipitous flight from bonds. If the risk of inflation in the near term is low, then investors should not be afraid of bonds as an asset class. Rising interest rates are the other principal risk to bonds, but that also seems unlikely in the near term. In any event, if you flee bonds, where do you go? To cash, which pays virtually nothing, or to an equity market which, taken as a whole, is probably overpriced? Second, remain vigilant for a wider outbreak of inflation by looking at a range of measures. Focusing only on headline inflation numbers which track commodity prices is tempting, but it is a potential trap. Broader inflation measures include the Consumer Price Index, the Producer Price Index, and broadest of all, but least well known to the general public, the GDP Deflator. The GDP Deflator tells us how much the price of goods and service rose across the economy. Third, avoid making any bets on inflation. We may see it coming, but anticipating exactly when or to what degree inflation flares up is unknowable. Instead of making a bet that may turn out to be unnecessary or, worse, damaging to your portfolio, there is time for an orderly review and adjustment of your asset allocation. A broadly diversified bond allocation, domestic and global, continues to be a good hedge against the risk of inflation. Replacing some bonds with other income producing assets is another good hedge. Lastly, watch out for unintended consequences and surprises. Over the last several years we have seen unprecedented government intervention in the economy and financial markets. The Fed may generally get what it wants, but sometimes it gets more than it bargained for. ---------- David Peartree, JD, CFP ® is an investment advisor with Ciccarelli Advisory Services, a registered investment advisor, offering fee-based investment management and financial advice to individuals and families. He can be reached at dpeartree@fscadvisors.com. Published: Thu, May 26, 2011