$10 salads, $4 gas, and low inflation

Posted by on February 6, 2012 @ 11:35 am in economy

Note: For an expanded look at Vanguard’s outlook for inflation—and an explanation of the data behind our analysis—read our interview with Joe Davis on vanguard.com.

As Vanguard’s chief economist, I’m often asked about inflation. And it’s an important topic. As the 1970s and early 1980s taught us, a persistent and unexpected run-up in inflation can significantly influence the economy, interest rates, and, by extension, the returns on stocks, bonds, and other investments.

Some of my friends are convinced that a return to the high inflation of the 1970s and early 1980s is inevitable. They point to the sharp rise in the Fed’s balance sheet (in addition to the temptation for governments to “inflate away” their national debt) as setting the stage for, at best, a return to 1970s-style inflation rates of 10% or more and, at worst, a significant crash in the U.S. dollar and stock market.

$10 salads, $4 gas, and … low inflation?

I admit that it does seem like the prices for the items I purchase most often (namely food and gasoline) only go one way—up. I know my grocery bills have. Just the other day, my salad at lunch cost over $10. Gas prices in some major cities remain above $4 a gallon, and they could approach that level nationwide this summer should the recent spike in global crude oil prices persist.

Indeed, your income may have failed to keep pace with the rise in the cost of living over the past decade or so. Of course, not all consumer goods and services have risen in price over that time. Price deflation for housing, furniture, electronics, and apparel have helped mitigate, at least partly, the unpleasant rises in food, energy, education, and medical care.

The end result is that the current measured rate of inflation is near its historical long-run average range of 2%–3%. According to the U.S. Bureau of Labor Statistics, through December 2011 the U.S. Consumer Price Index, or CPI, was up 3.0% for the year; core CPI—which excludes some of the very goods we seem to have no choice foregoing, like food and energy—was up 2.2%.

Are inflation fears … well, inflated?

Barring major unexpected shocks to the U.S. economy, Vanguard’s analysis leads us to believe it’s reasonable to expect U.S. CPI inflation to remain well contained for the next several years. And we are by no means alone in this expectation.

Of course, it’s important to acknowledge the inherent unpredictability of future events, and our outlook could prove off base. In fact, in the just-published Vanguard’s economic and investment outlook, we underscore this point by presenting a distribution of possible future inflation outcomes. We estimate that the likelihood of inflation averaging 5% or more over the next decade is approximately 10%—not trivial odds, but certainly not high.

So despite the unpleasantly high prices I’m paying for gas and groceries, I’m not currently losing sleep over the prospect for runaway U.S. inflation.

Still concerned? Here’s what you can do

If inflation keeps you up at night, the first thing you should do is appreciate the “inflation paradox” presently at work in the developed world. That is, the very actions of central banks to guard against deflation (such as the Fed keeping its target funds rate near 0%) can lead observers to worry about higher inflation in the future. And in a negative net-of-inflation interest-rate environment, it’s people who are saving money in conservative, low-yield vehicles who bear the brunt (see my July 2011 post, Monetary policy’s sacrificial lambs).

Second, keep in mind that a balanced portfolio of stocks and bonds has proven to be an effective long-term inflation hedge by providing a positive return over the inflation rate. Although nominal returns on a balanced portfolio may suffer a bit in a low interest-rate environment, our analysis persuades us that such a portfolio will likely produce a positive inflation-adjusted return over the next decade.

The third is to simply understand that radically restructuring your portfolio to provide more “inflation protection” comes at a price. Indeed, the price that global investors seem to be willing to currently pay for such “protection” (at least in the form of Treasury Inflation-Protected Securities or gold) seems high. Indeed, the real yield on the TIPS 10-year is near 0%, and the CPI-adjusted price of gold is near an all-time high.

Ironically, it’s this very inflation paradox that may be depressing the expected long-run returns on those investments believed to provide most “inflation sensitivity” in the short run.

Notes: All investments are subject to risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.

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