Inflation's Impact In Doubt

6/13/2011


Put five economists together, and you're likely to get twice that many opinions on inflation. They'll argue about whether you should fear inflation and how to combat it.

When inflation concerns arise, the Federal Reserve can raise interest rates to slow the economy and temper expectations of rising prices. However, if price increases prove transitory (think about the $40-to-$140-to-$40 roundtrip in oil prices in 2008), boosting interest rates can cripple the economy without impacting inflation.

While inflation has yet to reach dangerous levels, it is rising. The Consumer Price Index excluding food and energy rose 1.3% in the 12 months ended April, up from a gain of 0.6% in the year ended December. If you include food and energy, prices have jumped 3.1% over the last year. The chart below shows a sharp increase in commodity prices over the last 12 months.

As is the case with so many data points on Wall Street, the current level of inflation matters less than the expected direction and magnitude of change. And here, experts differ.

Some fear the economy hurtles toward the worst of all possible worlds — an economic recession accompanied by stubbornly high inflation, otherwise known as stagflation. Others, such as Federal Reserve Chairman Ben Bernanke, see the recent price increases as transitory, with the greater threat not higher inflation but an economic recovery still fragile enough to fall back into recession. Thus, while the Fed's $600 billion program of printing money to buy Treasury bonds is slated to end this month, it says it expects the fed funds rate to remain near 0% for "an extended period." Rumors of another round of bond purchases swirl, though comments from Fed bankers suggest near-term action is unlikely. The fed-funds futures market projects no interest-rate hikes until September of next year at the earliest.

Who is right? And, more importantly, does it matter? Should investors care about inflation at all?

We'll answer the last question first — all investors should care about inflation. Here's why:

• Higher inflation often accompanies higher interest rates — bad news for bonds, as prices tend to decline when interest rates rise. Most bonds pay a fixed coupon rate, and inflation erodes the value of that payment over time.

• Rapidly rising prices boost operating costs for companies. And if companies lack pricing power, those higher costs erode profits, which can lead to lower stock prices.

• Wall Street values stocks based on future growth prospects, and inflation erodes the present value of a dollar expected in the future. If high inflation causes the market to raise the discount rate for future cash flows, stock valuations compress. Higher inflation means lower P/E ratios, which means lower stock prices.

To be sure, the financial markets do not seem to view inflation as an imminent threat. The Dow Jones Industrial Average sits less than 7% below its nearly three-year high, and other market indexes enjoy similar positions. Ten-year Treasury yields fell to six-month lows early this month, and corporate yields are also declining, though not as quickly. Bond investors tend to accept lower yields when they see less risk of inflation.

In addition, the break-even rate — the difference between the yield of 10-year Treasury notes and Treasury Inflation Protected Securities — fell this month to its lowest point since mid-December. The rate (currently 2.05%) represents a rough proxy for expected annual inflation over the next 10 years.

Inflation is higher than it was six months ago. But that should not surprise us, as prices usually increase as economies expand. In a way, inflation validates the global recovery.

Weakness in the job market also puts a clamp on inflation. Sluggish hiring limits wage growth, perhaps the most dangerous contributor to the type of sustained inflation that hobbles financial markets.

At this juncture, investors concerned about inflation should harness the best weapon against any financial unknowable — diversification. On the equity side, that means:

• Including stocks of companies that have the pricing power to help offset higher costs, such as CSX ($75; CSX) and DirecTV ($48; DTV).

• Capturing dividend growth to help increase cash flow and ward off the effects of higher prices. Aflac ($45; AFL) and Exxon Mobil ($80; XOM) have delivered at least 28 consecutive years of higher dividends. Abbott Laboratories ($51; ABT) and Wal-Mart Stores ($54; WMT) have raised their dividends for at least 37 straight years, while Dover ($62; DOV) has 55 years of higher payouts.

• Gaining exposure to natural resources or commodities for an inflation hedge. Exxon Mobil, Hess ($75; HES), Newmont Mining ($53; NEM), and Walter Energy ($118; WLT) can help on this front.


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