Is It Time to Start Worrying About Inflation Again?

The greatest threat to any long-term investor is inflation. It not only erodes the value of stocks and bonds, but also depresses economic growth and misleads policymakers.

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People tend to forget about inflation during a recession, because it typically abates until a recovery gets under way. But now inflation appears to be coming back. Ignore the monthly numbers – they’re too volatile to be reliable. But Friday’s inflation report showed that consumer prices have risen 2.9% over the 12 months through the end of January. Moreover, there’s an even more worrying pattern if you look at the same measure at half-year intervals since the start of 2009. The series goes: minus 0.6%, minus 0.1%, 2.1%, 1.2%, 2.8%, 3.5%. With only one interruption, that trend shows inflation on the rise.

Some commentators argue that inflation isn’t a problem yet for several reasons: First, the consumer price index typically gives higher inflation readings than some other measures. Second, the economy is still relatively weak and unemployment remains high. That means any short-term price increases are likely to die out rather than fueling a self-sustaining inflation spiral. And third, policymakers have to balance the risks of inflation against the need to keep the economic recovery going and reduce unemployment. As long as unemployment is above 7%, inflation is a lesser risk than slipping back into recession.

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Those arguments are perfectly reasonable if you believe that government technocrats are generally able to fine-tune the economy and are also uninfluenced by political considerations. Unfortunately, neither of those things is true. The political problem is obvious: It’s easy to announce that you are going to cut interest rates or take other steps to stimulate the economy. But it’s much harder to raise interest rates or otherwise cause short-term economic pain for the sake of a healthier economy at some point in the future. The temptation for policymakers will inevitably be to wait and be sure unpleasant measures are absolutely unavoidable.

The other problem, though, is actually more serious – and a bit more complicated. Basically, it’s hard to know how much inflationary pressure has been created in an economy as long as it remains latent. Inflation can flare up, however, suddenly and with surprising strength. And at that point, it’s hard to reverse. Here’s the reason:

Inflation is the long-term rise in the overall level of prices. A one- or two-month blip does not qualify. Neither does a rise in, say, the price of oil, if it is offset by declines in other prices. A general increase in prices can only be sustained over the long term if the amount of money in circulation is growing. And that depends not only on the amount of money in the banking system, but also on the speed with which people spend it (known as velocity).

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In a recession, people spend less, so velocity slows and so does the economy. To offset that, the Federal Reserve pumps money into the banking system. Because the recent recession has been the worst since the Great Depression, Fed Chairman Ben Bernanke has injected an enormous amount of money into the system over the past four years. The only trouble is that as growth picks up, so does velocity. Sometimes velocity accelerates quite quickly – and that can cause a sudden and surprising jump in inflation.

Policymakers always risk erring in one direction or the other coming out of a recession – either prolonging high unemployment unnecessarily or creating inflation pressures that will do damage several years in the future. Political considerations argue for favoring the short run and erring on the side of stimulus. In an election year, that goes double. In addition, a little inflation might seem beneficial right now, since it would bolster home prices, helping both homeowners with excessively large mortgages and banks with bad real estate loans.

You can hope that the Fed and other policymakers get everything right. But there’s honestly no way for anyone to know the right policy mix. Prudence suggests that you should assume any warning signs of inflation you see are for real, especially since oil prices are rising right now (while high energy prices don’t cause inflation, they do help it along). In fact, gasoline prices are the highest ever for this time of year, and some experts think that gas could go as high as $5 a gallon this summer.

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When it comes to your investments, the best you can do is limit your exposure in the event that inflation does revive. As a rule, long-term bonds would be hurt worst, while money-market funds and short-term bond funds would suffer least. Stocks could be undermined because inflation makes price/earnings ratios contract. Among blue chips, the most vulnerable shares are those with P/Es above 20, low dividends and revenues that are unpredictable and highly sensitive to the state of the economy. The least risky stocks are those with P/Es of 16 or less, above-average dividends and popular brands or businesses that enable them to pass through price increases to customers. In short, a conservative strategy built around high-quality stocks with above average yields should continue to work if the economy starts to overheat a little, just as it has succeeded over the past few years.

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