Even though American inflation is currently under control, it still poses a risk to investors. The problem with inflation is that it erodes the real purchasing power of your money. But if inflation isn’t rearing its ugly head in today’s economy, why should investors be concerned?
The problem is that inflation affects other variables apart from the purchasing power of money.
When the American Fed purchases government bonds (as it has been doing), cash leaves the Federal Reserve and enters the economy at large, thereby increasing the money supply. In addition to infusing the economy with cash, the Fed keeps interest rates low in an effort to encourage borrowing money. However, some analysts fear that this combination could lead to a surge in inflation as more dollars chase a limited number of goods.
Other analysts believe that a low interest rate and increased money supply won’t necessarily boost inflation. This is because two other factors are needed to spur inflation: banks must be interested in lending and people interested in borrowing.
As a result of the financial crisis, American banks tightened their credit standards and borrowing levels decreased. Eventually the tides will probably turn, banks will want to lend, and people will increase their borrowing. At that point, the Fed must move quickly in order to avoid an increase in inflation.
The Fed believes that the expectations of inflation serve to increase actual inflation. Workers who anticipate inflation could demand raises, business could respond to higher salaries with higher prices, and then we’ll have a repeat of the wage-price spiral of the 1970s.
The “output gap model” asserts that an economy “operating below its potential” can prevent unwanted inflation levels. The definition of “operating below its potential” is unemployment – and therefore the Fed wants unemployment to remain above 5–6 % (which ironically for those unemployed is considered “full employment”). When the economy is weak, factories produce less and therefore need fewer workers.
However it’s difficult to measure how fast factories can increase production. And, the real cost of increasing production in a short time can also raise inflation.
Prices in the bond market often reflect inflation fears. By comparing the interest rates of regular bonds with the interest rates of Treasury Inflation-Protected Securities (TIPS), you may find the “breakeven inflation rate.” The breakeven inflation rate is the bond market’s prediction of what inflation might be in the future. As I write this, the breakeven rate suggests that the projected inflation rate over the next 30 years falls into the Fed’s acceptable parameters.
If you are concerned about inflation, or your portfolio’s ability to meet (beat) estimated inflation rates, speak with your financial advisor.
Douglas Goldstein, CFP®, is the Director of Profile Investment Service, Ltd., which specializes in helping people who live in Israel with their US dollar assets and American investment and retirement accounts. He helps olim meet their financial goals through asset allocation, financial planning, and using money managers.
Published May 20, 2012.