Anyone who has filled up their gas tank or paid their health insurance premiums recently will be shocked to learn that the Federal Reserve Board has been working hard to boost inflation.


You may be thinking, mission accomplished! Yet efforts continue, via the Fed’s second round of quantitative easing (QE2), in which the Fed is printing money to purchase bonds. Printing $600 billion to buy bonds increases the supply of money. When there are more dollars, each one is worth less, so the dollar weakens and prices increase.

However, some may question whether we need the Fed’s help to boost inflation. Revolution throughout the Middle East, the Japanese earthquake and resulting nuclear meltdown, and even our own improving economy are all contributing to inflation.

Uncertainty in the Middle East is, of course, mostly affecting oil prices, but increases in prices of transportation and petroleum-based products ripple throughout the economy. The increasing price of food is the most visible example.

Japan, meanwhile, accounts for about 9 percent of the world’s economy. What impact, for example, will the earthquake have on the sale of Japanese cars? Fewer Japanese cars will help American automakers, of course, but it will likely boost prices, too. Japan also produces 25 percent of the world’s semiconductors, so a lack of exports from Japan, combined with a growth in demand for imports, could have a dramatic impact on the price of many goods.
QE2, of course, began before the Japanese earthquake and the revolutions in the Middle East, but the Fed has not adjusted its plans. Perhaps the Middle East and Japan will stabilize without having a significant long-term impact on inflation; then again, would you be willing to place a bet on stability in the Middle East?

Remember stagflation?
In theory, inflation would help boost profits, which would, in turn, create jobs. But the relationship between inflation and employment is complex. It may be true that increasing employment will cause inflation, but that does not mean that increasing inflation will create more jobs.

Whether inflation creates jobs also depends on where prices are increasing. Currently, the prices of raw materials are, in many cases, reaching historic highs. If raw materials are more expensive, it will cost more to manufacture goods, so an increase in prices will not necessarily yield an increase in profits.
The weak dollar compounds this issue. It increases the price of imports, contributing to inflation, but also making domestic products comparatively more attractive. It makes American products cheaper abroad, but imported goods are used in most products today, so even exporters have to deal with higher prices. In addition, China is keeping its currency weak to prevent the U.S. from taking advantage of a weak dollar there.

These issues aside, the idea that increasing inflation will create jobs and spur economic growth is a throwback to the ‘60s and something called "the Phillips curve," which charted a relationship between prices and employment. It’s based on the idea that demand for goods not only drives up prices, it also encourages companies to hire more people to keep up with the demand.
However, the Phillips curve has been proven to be wrong and has generally been abandoned by economists (except those in The Fed, apparently).

The Phillips curve is right up there with the Keynesian theory that government spending stimulates the economy. While not all of the more than $800 billion allocated to the economic stimulus program a couple of years ago has been spent, it appears to have had no positive net impact on joblessness. The unemployment rate has finally fallen below 10 percent, but many Americans have stopped looking for work and are no longer included in the statistics.

Fear is growing that too much inflation will put a damper on the purchase of consumer goods, and slow the economy back down, resulting in higher prices without more jobs. High inflation with little or no growth is called "stagflation," a term that became familiar to many in the 1970s.

You may be hearing that term more in the near future. Already, stagflation is taking place in Asia and Europe.

What’s wrong with lower prices?
The Fed’s efforts to flame inflation are a reversal of its primary role since the 1970s, which has been to tame inflation. So why would it reverse course and try to cause inflation with two quantitative easing programs?

Out of fear of deflation. The Fed was worried about deflation because prices drop when the economy is weak and consumer demand drops. In periods of deflation, profits decrease, stock prices drop, and unemployment and bankruptcies increase. Consumers put off purchases and wait for prices to fall further, which contributes to even further deflation.

Prices actually dropped by 0.35 percent in 2009, but they had increased by 3.85 percent during the previous year.

It’s true that housing prices continue to tumble, with sales prices of single-family houses down 28 percent from a year ago, according to the U.S. Census Bureau, but, since most people are not buying homes this year, that will be little consolation for people who are paying higher prices for gas, heating oil, food, health care and most commodities. And it will create continuing misery for those who are trying to sell their homes.

The Fed is betting that consumer demand will stay low enough to keep inflation at moderate levels, so it hasn’t stopped QE2. There has even been some talk of a QE3.

If nothing else, QE2 has played a major role in giving the stock market a boost during the past quarter, but it is, of course, much better to have stock markets boosted by healthier corporate profits and economic improvement.

Preparing for inflation
The Fed is often criticized, but it has done a good job controlling inflation for nearly three decades.

In recent years, inflation has typically been two to three percent a year. Compare that with the 1970s and early 1980s. In 1974, the inflation rate was 11.03 percent and from the period 1979 through 1981, inflation was 11.22 percent, 13.58 percent and 10.35 percent.

When inflation is high, investors need higher returns just to stay even. If your investments earn 8 percent, for example, and the inflation rate is 10 percent, your real rate of return is minus 2 percent. In other words, your standard of living will drop if your investments don’t make more than the rate of inflation.
The stock market has been posting healthy returns, but those returns (boosted by QE2 and other factors) in many cases do not appear to be grounded in sound fundamentals. Stock prices may, in fact, be too high and many believe the market is due for a "correction."

Keeping your money in low-interest savings accounts, money market funds or certificates of deposit may be the worst option. While interest rates are likely to increase, it is doubtful that they will increase enough to keep up with inflation.
And, of course, rising interest rates have a negative impact on bonds.

As we always recommend, a well-diversified portfolio is a good starting point. Investing internationally could be especially beneficial if you can identify countries with greater stability and potentially lower inflation than the U.S.
Another option is to consider Treasury Inflation Protected Securities (TIPS), which are designed to provide a hedge against inflation. The principal for TIPS is adjusted for inflation monthly, rising or falling based on the Consumer Price Index (CPI).

If the CPI increased 10 percent, for example, $1,000 invested in TIPS would be worth $1,100, plus the owner would receive income from yields.

Be aware, too, that expectations of higher inflation will cause an increase in demand for TIPS, which will cause prices to increase and yields to decrease.
Perhaps the best advice is not to over-react. Stagflation would cause a decrease in stock prices, but if you are a long-term investor, patience should pay off.

Past performance is no guarantee of future performance, but remember how quickly the market recovered from the bear market of 2008 and 2009. Those investors who stuck with the market saw their investments come back.

Stagflation could be difficult, especially on the heels of the financial crisis we’ve been living through over the past few years. If it does, indeed, come, keep in mind that we’ve lived through it before and the probability is high that we will persevere and get through it again.

Darrell J. Canby, CPA, CFP(r) is president of Canby Financial Advisors LLC, a registered investment adviser at 161 Worcester Road, Suite 408, Framingham. He offers securities as a Registered Representative of Commonwealth Financial Network, Member FINRA/SIPC. He can be reached at 505-598-1082 or dcanby@canbyfinancial.com.