A Question That Could Stump Watson

Recently, IBM developed a super computer called Watson that is capable of solving complex thought problems. The power of the machine was demonstrated by its ability to defeat two of the best known Jeopardy champions on the popular game show.  The Investment Policy Committee has recently been wrestling with an issue that has the potential to overheat the super computers circuits: will there be an increase in inflation in the coming months and if so, when will it start and how large will it be?

To answer any difficult question, it is best to start by answering some basic questions.  What is inflation, how is it measured, what causes inflation, and what are its consequences?  Simply put, inflation is a sustained increase in the general price level.  This implies that a one-time increase in a specific good or commodity or an increase in one specific item are not examples of inflation.  In other words, the “general price level” is referring to an overall increase in the amount you pay for goods and services in total.

Given that inflation refers to a price increase across a large number of goods and services, measuring inflation is a difficult process.  That task falls to the Bureau of Labor Statistics which monitors the consumer price index (CPI).  The index tracks price changes in a “basket” of consumer goods and services in over different 200 categories or products.  The Bureau of Labor Services actually conducts monthly price surveys on all of the goods across multiple geographic points to determine if there has been a change in the price of the overall basket of goods.  From that, data changes in the consumer price index are announced providing an indication of an increase or decrease in the “general price level.”  The Bureau also announces changes in specific categories of goods such as transportation and energy.  Often these areas may have increases in prices while the rest of the economy does not.

Causes and Consequences

The traditional cause of inflation is consumer demand for goods and services being greater than the supply of goods.  This creates a case where consumers increase the price they are willing to pay for what they desire.  Often this is associated with the idea of too much money chasing too few goods.  One point in time when this can happen is when borrowing rates are low, allowing for an increase in the amount of money consumers will borrow. Given the efforts of the Federal Reserve to keep interest rates low by increasing the amount of money available for lending it is a natural question to ask if this policy will cause inflation.  A second cause of inflation comes from a shortage of goods desired by business.  Often this is referred to as coming from the “supply side” of the economy. In this scenario, raw materials such as oil, copper and gas are in short supply and producers must pay higher prices for their inputs. These cost increases are then passed on to consumers in the price they pay for goods and services. The fast growth in global demand for these goods and the uncertainty in the Middle East have created an increase in energy and commodity prices, creating a potential increase in supply side inflation. According to the World Bank, global food prices have increased 29% in the past year.  This increase has contributed to the unrest in the Middle East.

In either case, inflation erodes the return you receive on an investment.  Simply put, a 7% return on your investment will not allow you to buy 7% more goods if prices increase.  Therefore, it is key for the Investment Policy Committee to take steps to protect your investments against inflation.

Will Inflation be a Problem?

The key debate today is whether or not inflation will materialize, and if it does how high will it be?  The Federal Reserve has indicated that its efforts are not as inflationary as many in the media believe.  In fact, at the end of January, year on year inflation was at 1.7%, well within the Fed’s comfort level.  And forecasts for inflation for 2011 are under 2.0% with core inflation lower.  The reason inflation is at a low level is due to the weakness in the labor market which does not have bargaining power and weakness in the housing market.  Both of these factors are projected to continue in the near term.  But the tightness in global commodity markets and inflation in food and energy prices are disconcerting.  The Fed’s rationale for low inflation is based on the belief that the total amount of money in the economy has not increased dramatically; it is just housed in a different location.  While that may be the case, the different location is in the form of liquid assets which may come into the economy quickly in the form of loans as the economy picks up.  Therefore, combined with the strong global growth, the investment policy committee believes it is prudent to plan for a potential increase in inflation.

Protecting Against Inflation

So what is River Glen doing to protect our clients’ portfolios from the negative impacts of rising inflation?  Over the past year, we have increased our exposure to commodities.  Commodities will move quicker than other inflation sensitive assets in response to rising costs. They should also offer a hedge for stock and bond investments that would be negatively impacted by increasing inflation.

In addition, with the Feds increase in the money supply and the issues of U.S. debt, there is concern about the long term strength of the U.S. dollar.  Therefore, we have added exposure to international corporate bonds to our client portfolios.  Both of these actions, increasing exposure to commodities and adding exposure to international corporate bonds, should add protection during these uncertain times.

If you have questions about this article or have questions about how inflation impacts your portfolio, please contact our office.

-Investment Policy Committee