INSIGHTS

On April 21, 2011

Could the U.S. Return to 1970s Style Inflation?

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The U.S. appears to be at the crossroads of fiscal and monetary policy. Many are painting a very bleak picture of the future of the dollar, U.S. credit and the validity of the U.S. economy as the model for the world.

Could the U.S. return to 1970s style of inflation? The answer is that, although the possibility is there, the probability that such a high level of inflation returning any time soon is actually very low, in our opinion. Is the Fed conducting monetary policy that is inflationary in nature? Yes they are, but let's not forget why they are doing this. The Fed is engaged in the avoidance of deflation.

Deflation is a condition when too few dollars are chasing too many goods and services. Lower prices may seem attractive to consumers but it destroys growth in an economy. Japan has experienced two decades of deflation that has crippled their economy since it peaked in 1990. The U.S. has suffered a hint of deflation twice in this decade. In the most recent recession, U.S. asset values declined dramatically in dollar terms. Wealth in real estate declined the most in history as paper assets such as equities, suffered major declines. The destruction of this wealth and demand created an environment conducive to deflation.

Case in point: the U.S. housing market. Demand for housing has dropped precipitously over the past two years, even as affordability has skyrocketed. Housing buyers delay their purchase decisions if they perceive that prices will continue to decline. Reversing this spiral can only be accomplished by creating demand. Demand can only be created by creating conditions that instill a sense of value and urgency into a prospective buyer's mind.

The Fed is creating urgency to purchase risk assets by destroying the rewards of traditionally "safe" risk-adverse assets. The Fed is purchasing Treasuries from sellers who it hopes will move those dollars to more risky assets. The Fed is not buying Treasuries because they think there is value there; they are creating demand (velocity) for risk assets. We believe the rise in the value of other asset classes (equities, commodities, etc.) is proof that the Fed’s plan is working. The rise in inflation expectations is exactly what the Fed wanted and what it is getting.

Real inflation is most likely a ways off. The reason for this is that most of the input costs of goods and services in the U.S. are labor costs versus raw materials. Labor costs have moderated dramatically with the unemployment rate's recent spike to almost 10%. Thus the major input cost in U.S. goods and services is actually moderating even in the face of rising raw materials prices. Back in the 1970s when inflation gripped the United States, the majority of input costs were raw materials. This is simply not the case today.

What about interest rates? Will they rise? The answer is yes, but when is really the question. We believe that with tepid demand for U.S. goods and services (GDP), it is highly unlikely the Fed will begin to raise short-term rates soon. Also as demand remains robust for longer dated bonds, we see little evidence that inflation is a problem in the near term. Thus, timing is everything. There is a huge opportunity cost in avoiding assets that present oversized reward with moderate risk. The investment world is now mostly invested in cash or *short duration debt as a risk-adverse path. This is most likely the worst place they could be, in our opinion. As they stay short fearing a rise in rates, they stay in dollars that will most likely lose purchasing power at a rate faster than the fractional interest they are earning. Thus once again, we think the crowd is probably in the wrong place.

Are the Fed’s actions destroying the value of the dollar? Our answer is unequivocally yes. A slow debasement of the currency is not new. The U.S. began to devalue the dollar beginning back in the 1960s when the United States worked its way into a policy of increasing the population of U.S. dollars and running fiscal deficits funded by debt. A slow devaluation of the dollar actually has many positive affects. It makes our goods and services more competitive in global markets. Recent earnings reports from our multi-national companies confirm our suspicion. We think that although they can't state it, this is part of the Fed’s intended consequences.

With U.S. companies able to be more competitive and sell more goods and services, then what is bad about destroying the value of the dollar? The counter argument is that we are destroying the value of the dollar by devaluing it. The world depends on the dollar as its reserve currency. Destroying the value of the dollar could lessen the faith in our currency. If the faith in the dollar is destroyed then our currency becomes less desirable for holders to own. If holders begin to sell the dollar in favor of other currencies then the downward move can snowball and a crash of the currency ensues. There have been several examples of this in history that include post World War I Germany and, more recently, Venezuela.

Finally, devaluing the U.S. dollar has the painful affect of creating inflation in countries where their input prices are still mainly raw materials. These are countries where their economies are heavily reliant on commodities. Look at countries such as Australia and Brazil as examples. Their currency is appreciating against the dollar, making their exports less desirable. They are each very unhappy with U.S. monetary policy as we are creating inflation in their countries as well as retarding their competitiveness. The problem they confront is that there is no ready replacement for the dollar. We are seeing gold and silver re-emerge as forms of currency, and we believe hard assets will continue to be sought out as capital looks to retain its value.

Is the Fed doing the right thing? Our answer is probably yes. Easing the value of the U.S. dollar will make the United States more competitive. Whether they can control the devaluation is the bigger question. The risks here are very high.

How do investors invest for income when they fear higher interest rates might erode their investment in longer dated bonds? Many suggest a bond ladder, which is a simple way to keep duration pegged in a portfolio. We think a look at the playbook from the 1970s might be worthwhile. Back then, rates were rising and commodity prices were soaring. Investors stayed short as they wanted to benefit from rising rates. The key then was to hedge the bond portfolio against inflation. Commodities presented a great way to do that. We feel that investors must consider how to profit from our current scenario rather than where to hide. We believe that a rally in commodities continues as the dollar continues to slump. We believe that inflation will return, but it might be years away as the United States struggles to reduce the ranks of the unemployed. Investors should take on some credit and maturity risk according to their tolerance, in our opinion. Inflation risk should also be addressed. For investors that need fixed income, a small amount of commodities has historically been an effective hedge if and when inflation returns.

*The term “short” refers to the sale of a borrowed security, commodity or currency with the expectation that the asset will fall in value.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com/blog.