Dictionary Series - Economics: inflation

While the United States’ fourth-quarter gross domestic product report was a disappointment on many fronts, it did contain a few silver linings. One of these positives: The noticeable absence of meaningful inflation.

For many investors who have been watching the Federal Reserve’s increasingly heroic efforts to stimulate the economy, this likely comes as a bit of a surprise. But while the Fed continues to push down on the monetary accelerator, any concerns about imminent US inflation may be premature because:

  1. There is no wage inflation. Overall wage growth in the United States remains sluggish. The reason: The labor market is healing at an agonizingly slow pace. U-6, a broad measure of unemployment that also includes part-time workers looking for full-time work, is still indicating that about one in six American workers are unemployed or underemployed. Until this changes, raises will be hard to come by, and without wage inflation, overall inflation is likely to remain muted.
  2. Bank lending is only starting to pick up. While the Fed has been busy in recent years with the modern equivalent of a printing press, the newly created money has been mostly sitting on bank balance sheets.  Without much bank lending, growth in the money supply has been modest, lowering the risk of inflation. Though bank lending is starting to rise again, at least to businesses, it will take time before credit creation leads to any meaningful pickup in inflation.

However, while slow wage and credit growth mitigate the near-term risk of inflation, investors are right to be worried about inflation in 2014 and beyond as:

  1. The Fed will eventually need to end its economic stimulus. It’s unclear how adroit the Fed can, or will, be when it comes time to unwind its extremely accommodative monetary policy.
  2. Monetary and fiscal policies are now hopelessly intertwined. In other words, when the Fed finally decides to raise rates and shrink its balance sheet, it will seriously exacerbate the government’s already sizable deficit. When that happens, given the United States’ serial failures to address its fiscal imbalances, there’s a good chance the government will look to higher inflation, a weaker dollar, or both as tools to mitigate the burden of an ever-growing national debt.

So what should investors be doing today? While inflation may take another year or more to get going, it’s not too early to start implementing long-term inflation hedges. These can include: natural resource and energy companies, accessible through the iShares S&P Global Energy Sector Fund (NYSEARCA: IXC); international equity markets with large commodity exposure such as Australia or Brazil, accessible through the iShares MSCI Australia Index Fund (NYSEARCA: EWA) and the iShares MSCI Brazil Index Fund (NYSEARCA: EWZ); physical real estate; and of course, gold.

But investors may want to consider avoiding one hedge: Treasury Inflation-Protected Securities (TIPS). While TIPS will protect purchasing power, this protection comes at a hefty price. Real yields on TIPS are currently negative. In order to have the government guarantee purchasing power, investors in TIPS basically need to pay a fee. In contrast, cheaper ways to hedge inflation — energy stocks, for example — may actually pay investors while they wait.

Source: Bloomberg

Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog.  You can find more of his posts here.

Disclosure: Author is long IXC, EWA and EWZ

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