The Federal Reserve isn't worried about inflation. But the smart money is betting that it's a clear and present danger.
The Fed said Wednesday that the economy is still too weak to worry about inflation and announced it will hold the target range for the federal funds rate at 0% to 0.25% in an effort to keep money easy to obtain.
"Inflation will remain subdued for some time," the central bank said in a written statement.
Many professional investors disagree, though, and they're rapidly moving into commodities, precious metals, Treasury inflation-protected securities and other areas that maintain their value during periods of inflation.
Inflation is worrisome for several reasons. It erodes the future value of income, making it more difficult for workers to retire. It also decreases the value of the dollar relative to other currencies, making it more difficult to buy imports or travel.
Perhaps most importantly for investors, inflation makes buying equities and bonds more risky. Inflation typically causes the cost of business raw materials to rise before those costs can be passed on to consumers in the form of higher prices. The higher prices of raw materials eat into companies' margins, eroding profits and shareholder returns. And inflation obviously damages the value of cash.
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"In the short term, I expect deflation to get halted in its tracks, and I expect monetary policy to remain easy," says John Brynjolfsson, the chief investment officer at hedge fund Armored Wolf. In the long term, however, he says inflation could rise from 4% to 6%.
Why inflation is around the corner
The government wants inflation to some degree. Congress and the White House have spent nearly $3 trillion recapitalizing U.S. banks, revamping the domestic manufacturing industry and replacing a portion of the consumption spending Americans have not been able to afford. The economy is recovering as a result, but U.S. debts are also ballooning. The nonpartisan Congressional Budget Office projects that the U.S. deficit will exceed $1.8 trillion this year.The government doesn't plan on paying off that debt or the interest on it without some help from the Fed. Earlier this year, the central bank announced it would directly purchase $1.75 trillion worth of U.S. debt in the form of mortgage-backed securities, U.S. Treasurys and agency debt. In essence, the Fed's action "prints" more money and injects it into the economy.
"(Government officials) are using over a trillion dollars trying to increase the money in the system," says Brian Weinstein, a managing director at BlackRock who runs the investment firm's inflation-protected assets business. "The Fed hasn't really done this before."
Under most circumstances, adding to the money supply is inflationary. However, Federal Reserve Chairman Ben Bernanke has argued that there is so much pressure on prices to drop, because of the $14 trillion in wealth that has evaporated during the past two years, that buying Treasurys should serve only to keep deflation at bay.
Maybe, but the Fed has taken other inflationary actions. By keeping interest rates low, the Fed is encouraging people to borrow and spend. And the more people spend money, the more pressure there is on prices to rise, driving up inflation.
Already, prices have started to rise in some sectors. The Consumer Price Index increased 0.3% in May, compared with the prior month, according to the Bureau of Labor Statistics. Food and beverages are, on average, 2.7% more expensive than they were last May. The prices of clothing, medical care and education have also risen for the year. Even housing prices are up slightly.
Worryingly, energy prices are on their way up, too. Though energy prices in May were down 27.3% from a year earlier, oil and gas have recently rallied. Crude prices have risen about 25% in the past three months.
Some of that increase is due to China's decision to increase its crude reserves to fuel future domestic projects. Much of it, however, is due to speculation that a recovering U.S. economy will need more oil -- thus boosting demand and pushing up prices -- as well as investor anticipation that inflation will cause commodity prices to rise.
Speculation about inflation can have a similar impact to inflation itself. Investors who anticipate the purchasing power of dollars to erode will buy commodities that tend to retain their value and increase in value relative to inflation. Such commodity hedges, in turn, lead to more demand for commodities and higher prices.
"You have to worry about actual inflation and anticipated inflation," explains Weinstein, adding that the market is pricing in inflation by 2011. "We don't know when inflation is going to happen, but when we see it, it will be too late."