Inflation has not materialized despite the Fed's accommodative monetary policies.
But inflation risk remains a threat for investors.
It is better to protect your portfolio against inflation risk now before prices rise and it is too late.
With all the talk about slow growth and low interest rates, it is easy to forget about inflation. The rate of inflation has been down for about 30 years in the United States. In Europe and Japan, policymakers are more concerned about deflation than inflation. But inflation is not dead. It is a sleeping tiger.
The U.S. Federal Reserve operates under a dual policy mandate:
- Low unemployment; and
- low inflation.
Since the financial crisis and the Great Recession, the Fed has thrown everything but the kitchen sink at the unemployment problem in the United States. Short-term interest rates are near zero.
The Fed has engaged in a controversial, non-traditional monetary stimulus program aimed at keeping long-term interest rates down to incentivize borrowing, spending, and investment. Below is an image showing the Fed's ballooning balance sheet:
Source: Federal Reserve Economic Data by the Federal Reserve Bank of St. Louis.
American economist Milton Friedman once said, "Inflation is always and everywhere a monetary phenomenon." Despite vocal opposition to the Fed's expansionary policies, U.S. inflation has remained calm, running at about 2%. This amount is in line with the Fed's target inflation rate.
Tapering Has Begun
In December 2013, the Fed announced that it would start to unwind its non-traditional stimulus measures, collectively known as "quantitative easing." The Fed has begun tapering its multibillion-dollar bond purchases. Based on the Fed's current pace of monthly asset purchases, the bond-buying stimulus initiative will be finished this fall.
Accommodative monetary policies have helped to address U.S. unemployment woes. Since reaching a high of 10% in October 2009, the unemployment rate has dropped to 6.3%, according to the U.S. Department of Labor.
Watch out for Inflation
Critics maintain that the Fed's expansionary policies could eventually result in upward pressure on general price levels due to an excess supply of money. Inflation is so powerful it can destroy an economy.
In 1919, British economist John Maynard Keynes expounded upon the threat of inflation as follows: "There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose." In Germany, starting in the World War I era, the exchange rate rose from about 4.2 German marks per U.S. dollar in 1914 to about 4.2 trillion marks per dollar in 1923, according to The Economist.
In the most recent minutes of the Federal Open Market Committee meeting, released May 21, the Fed stated that it did not presently "face a trade-off between its employment and inflation objectives." Moreover, the Fed indicated that "an expansion of aggregate demand would result in further progress relative to both objectives." That's a remarkably stress-free statement by a central bank when it comes to inflation risk. The reasons given by the Fed for this statement were:
- Inflation is expected to stay below the Fed's 2% target rate; and
- unemployment is still higher than normal.
Inflation is one of the primary risks faced by investors. The cost of a U.S. stamp is a good example of inflation. In 1974, it cost 10 cents to mail a letter. Today, mailing that same letter costs 49 cents, according to the U.S. Postal Service.
How to Protect Against Inflation Risk
While inflation is tame at the moment, the risk of inflation does not disappear. Real, tangible assets perform well in an inflationary environment. Real estate, precious metals, and commodities are examples of real assets.
The Schwab U.S. REIT ETF (NYSEARCA:SCHH) is an excellent, low-cost choice for broad exposure to the real estate sector. It is an index-tracking fund that follows the Dow Jones U.S. Select Real Estate Investment Trust Index. The SPDR Gold Shares ETF (NYSEARCA:GLD) offers shares in a trust that owns physical gold stored in London vaults protected by armed guards. Third-party audits ensure that the gold bullion exists. The SPDR Gold ETF is the largest fund of its kind.
In addition, Treasury inflation-protected securities, or TIPS, offer a way to protect your portfolio. TIPS provide the safety of treasuries with an adjustment to principal based on the Consumer Price Index. The Vanguard Short-Term Inflation-Protected Securities ETF (NASDAQ:VTIP) is a good choice. As a short-term fund, it is designed to be more closely correlated with annual changes in inflation than longer-term TIPS funds.
Rather than being complacent, it is good to plan for inflation coming back down the road. Real-asset funds and TIPS provide ways to protect your portfolio against the sleeping tiger. Adding these assets can help to diversify your investment mix. It is better to fix the roof of your house now before the rains come and it is too late.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.