Is Higher Inflation on the Horizon?
By Orhan Imer
July 10, 2012
For nearly two decades inflation in the U.S. has been fairly contained except for a few periods of moderate acceleration around peak levels of economic activity. More recently, headline inflation as measured by the year-over-year change in the CPI-U (Consumer Price Index for Urban Consumers) declined from 3.9% in September 2011 to 1.7% in May 2012 driven primarily by the slowdown in the U.S. economy and the sharp drop in energy and commodity prices.
While the current level of inflation remains subdued, investors should be prepared for risk of longer-term inflation associated with highly accommodative monetary and fiscal policy actions taken by the Fed and the U.S. Government since 2008.
During the past several years, the Fed’s monetary policy decisions, intended to stimulate U.S. growth, have become less centered on containing inflation. In particular, the Fed’s near-zero interest rate policy and expanded balance sheet along with deficit spending by the government to lift the economy out of recession have raised the risk of future inflation. Other conditions that may add to inflationary pressures over the next decade and beyond include:
1) Accelerated government spending on healthcare and other non-discretionary spending programs (such as Social Security, Medicare and Medicaid) necessitating continued high levels of federal borrowing
2) Demographic shifts in the U.S. population as baby boomers begin to retire leading to lower savings and productivity
3) Higher tax rates on income and capital gains raising the cost of capital dampening capital investment and productivity
4) Weakening of the U.S. dollar due to Fed’s interest rate policy and massive monetary easing which may promote inflation through higher energy and commodity prices
5) Emerging market countries representing a growing share of global GDP and driving up the demand for scarce resources (commodities, land and other real assets)
While the recent slowdown of the global economy along with the continuing weakness in the U.S. housing market and excess manufacturing capacity in many industries may keep inflationary pressures at bay near term, investors should protect themselves against unexpected inflation, as surprises in inflation can have a meaningful impact on the performance of inflation-sensitive assets.
With nominal interest rates at historically low levels, we believe Treasury Inflation Protected Securities (TIPS) offer some protection against unexpected future inflation while at the same time providing some diversification benefits to a fixed income portfolio.
Further insight into the market’s outlook for inflation can be gained by analyzing the breakeven spread between the yield of a nominal Treasury security and the real yield of the closest maturity inflation protected Treasury security. The 10-year breakeven spread has been relatively stable over the past decade hovering around 2.5% with the exception of a brief period during the height of the financial crisis in the fall of 2008.
The TIPS market is currently pricing in a low growth and a muted inflation environment with the 10-year breakeven spread at 2.1% as of July 6, 2012.
We believe that fixed-income investors may benefit from owning real rather than nominal assets as expectations re-adjust to the risk of higher inflation in the future.
The views expressed are as of 7/9/12, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts are accurate.
Diversification does not assure a profit or protect against loss.
There are risks associated with fixed income investments, including credit risk, interest rate risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is more pronounced for longer-term securities.
Investment products are not federally or FDIC-insured, are not deposits or obligations of, or guaranteed by any financial institution, and involve investment risks including possible loss of principal and fluctuation in value.
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