Inflation: Are We Victims of Irrational Pessimism?

by: James Picerno

Inflation, we're told, isn't a problem, and won't be any time soon. But we worry about the threat just the same. Maybe we're a victim of irrational pessimism.

Whatever afflicts our powers of analysis, there's no question that inflation's had a pretty good run since the Federal Reserve's founding in 1913. Yes, recent history offers reason to argue that the central bank has finally figured out how to tame the beast. Maybe, although we'll continue to reserve judgment, thank you very much. It's our money, after all, and we're reluctant to watch it slip away, in either relative-purchasing-power terms or through outright capital losses.

That said, we're not obsessed with inflation, or so we believe. Our allocation to gold, TIPS and other hedges against upward pricing pressures is still modest, bordering on insignificant if inflation were to come roaring back tomorrow. And by rank-and-file gold bug standards, our investment strategy could be confused with thinking that inflation has forever been banished.

Still, your editor recognizes that, in the long run, the political and economic pressures to inflate are potent, as a careful study of the past reminds.

Even at today's reportedly modest rate of inflation, the damage adds up as the years pass. Consider that what cost $100 in 2000 now, on average, sets one back to the tune of $120, according to the inflation calculator on the Bureau of Labor Statistic's website. In other words, a dollar's worth 20% less today than it was just seven years ago. That disturbing state of affairs has unfolded during what officially hailed as a triumphant suppression of inflationary forces!

The above calculations come by way of the government's definition of inflation, as per the consumer price index, [CPI]. By some accounts, the definition underestimates the true extent of pricing pressures. But for most investors, the opportunities are limited for hedging away inflation's corrosive effects. Gold, of course, is a traditional strategy, although few are willing to will hold more than a token amount of the metal. There's also the vast world of collectibles and commodities, but any number of issues plague this realm as practical tools for inflation-fighting inflation, ranging from illiquidity to volatility to lack of pricing transparency.

For most investors, that leaves inflation-protected Treasuries, or TIPS, as the more practical choice. But since the bonds are tied to the CPI, buying them requires a certain amount of faith in the underlying benchmark. For some, that's asking too much, as we reported in the June issue of Wealth Manager magazine. Nonetheless, as the article reminds us, most investors are stuck with the CPI.