Inflation lurking? Adjust portfolio, just in case
You probably know someone who can find the darker side of anything. You struck oil in the back yard? The Environmental Protection Agency will be all over you. You just won the lottery for $45 million? Don't you know the government will take a third of it in taxes?
Today, we're going to be that nattering nabob of negativism. You know those lower interest rates the Federal Reserve gave us on Tuesday? They could eventually trigger inflation - and we could pay for those low rates in the form of higher prices for a long time.
Fortunately, you can adjust your portfolio to protect your savings by investing in gold, inflation-adjusted bonds or investments denominated in foreign currencies.
Of course, lower rates do bring benefits. The Fed knocked a half a percentage point off its key fed funds rate, pushing the rate down to 4.75 percent. The Fed's actions will have three immediate effects:
- Lower savings rates. Interest rates on money market funds, bank CDs and other short-term savings vehicles will fall by about a half a percentage point.
- Lower borrowing rates. Rates on home-equity loans and credit cards will fall about half a percentage point, which means lower monthly payments.
- Higher liquidity in the financial markets. On Wall Street, liquidity isn't the amount you drink after sealing a million-dollar deal. It refers to cash - or assets that can be converted to cash quickly. When there is plenty of liquidity on Wall Street, interest rates are low, and borrowing is easy. When liquidity dries up, rates rise, loans are hard to get and the financial system can grind to a halt.
The Fed lowered rates by making more money available to lend, thereby boosting liquidity in the financial system and easing Wall Street's worries about the credit crunch.
The Fed has earned lots of kudos for its bold action. But unfortunately, the Fed's rate cuts also raised the fear that inflation will rear its ugly head. Inflation (a period of rising prices) has its own perverse appeal for some. In an inflationary period, companies are able to raise prices, workers get bigger raises and fixed-rate mortgage payments remain the same.
If inflation rages out of control, though, it can destroy the public's faith in its own currency. In Germany in the early 1920s, prices doubled every 24 hours. But even a little bit of inflation can hurt. Inflation has been relatively modest, for example, in the past 10 years, yet the buying power of $100 has fallen to $76 since the start of 1997 - a 24 percent decline.
The Fed was already worried about inflation before the credit crunch turned serious in August. In fact, it had been raising rates to slow the economy and ward off the threat of inflation. Now, by lowering rates, it might be fanning the flames of inflation. And in fact, inflationary pressures are already high:
- Energy. Light, sweet crude for October delivery closed Thursday at a record high (not adjusted for inflation) of $83.32 a barrel.
- Currency. The value of the U.S. dollar has hit new lows against the euro: It now takes a bit more than $1.40 to buy one euro. A falling dollar makes imports - such as toys from China - more expensive. And the Canadian dollar is now worth slightly more than a U.S. dollar. Canada is our largest trading partner.
- Employment. Though wage growth is relatively modest, unemployment is a low 4.6 percent, indicating a tight labor market and, possibly, further wage gains.
The Fed received some good news on inflation earlier this week when the Commerce Department reported that consumer prices declined 0.2 percent in August. So far this year, though, inflation is running at a worrisome 3.7 percent rate.
How can you protect your portfolio from inflation?
- Avoid bonds. The bond market views inflation the same way that Superman views kryptonite. Inflation erodes the value of a bond's fixed interest payments. On Thursday, traders slashed the price of 10-year Treasury notes on inflation fears.
- Consider inflation-adjusted bonds instead. Treasury inflation-protected securities, or TIPS, increase in value as inflation rises. TIPS base their value on the consumer price index, which includes the volatile food and energy components. If oil continues to soar, you'll get some benefit from TIPS.
- Go for gold. Gold is the traditional hedge against inflation. Gold rises in value when paper money becomes worthless. During the Civil War, investors would buy gold after a Confederate victory, under the assumption that greenbacks would fall in value.
Gold is a good hedge against a falling dollar and against inflation. Mutual funds invest in the stocks of gold mining companies, whose prices often outpace the gains in the spot price of gold.
But beware: Few funds are as volatile as gold funds. Keep your holdings to about 5 percent of your portfolio as an inflation hedge.
For the moment, let's hope inflation is in check. But just to be on the safe side, it's not a bad idea to take a few precautions. You never know.
WBJ Web Partners
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