Is Higher Inflation on the Horizon?

by Orhan Imer, Ph.D., Columbia Asset Management

For nearly two decades, inflation in the U.S. has been fairly contained except for a few periods of moderate acceleration around peak levels of economic activity. More recently, headline inflation as measured by the year-over-year change in the CPI-U (Consumer Price Index for Urban Consumers) declined from 3.9% in September 2011 to 1.7% in May 2012, driven primarily by the slowdown in the U.S. economy and the sharp drop in energy and commodity prices.

While the current level of inflation remains subdued, investors should be prepared for risk of longer-term inflation associated with highly accommodative monetary and fiscal policy actions taken by the Fed and the U.S. Government since 2008.

During the past several years, the Fed’s monetary policy decisions, intended to stimulate U.S. growth, have become less centered on containing inflation. In particular, the Fed’s near-zero interest rate policy and expanded balance sheet along with deficit spending by the government to lift the economy out of recession have raised the risk of future inflation. Other conditions that may add to inflationary pressures over the next decade and beyond include:

1. Accelerated government spending on healthcare and other non-discretionary spending programs (such as Social Security, Medicare and Medicaid) necessitating continued high levels of federal borrowing
2. Demographic shifts in the U.S. population as baby boomers begin to retire leading to lower savings and productivity
3. Higher tax rates on income and capital gains raising the cost of capital dampening capital investment and productivity
4. Weakening of the U.S. dollar due to Fed’s interest rate policy and massive monetary easing which may promote inflation through higher energy and commodity prices
5. Emerging market countries representing a growing share of global GDP and driving up the demand for scarce resources (commodities, land and other real assets)

While the recent slowdown of the global economy along with the continuing weakness in the U.S. housing market and excess manufacturing capacity in many industries may keep inflationary pressures at bay near term, investors should protect themselves against unexpected inflation, as surprises in inflation can have a meaningful impact on the performance of inflation-sensitive assets.

Read more in this week’s Perspectives.

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