We will probably not see any meaningful increase in inflation in 2011 or 2012.  Despite polls of consumers who collectively are certain inflation is just around the corner, and numerous market commentators who believe that the governmental stimulus efforts make inflation inevitable, the more likely scenario is that inflation will not be rising anytime soon. 

In this article, I will explain the rationale for inflation remaining benign despite the common thinking that it is inevitable and the evidence in our daily lives that prices are rising.  There is no question that we have all experienced higher gasoline and food prices over the last several months.  The price of crude oil has risen over $100 a barrel, up 40% from last year.  The prices of corn and wheat have risen even more, increasing by over 100% over the past year.  Even industrial metals, such as aluminum and copper, have increased significantly.

However, as Boston Federal Reserve Bank researcher Geoffrey Tootell wrote recently “evidence from recent decades supports the notion that commodity price changes do not affect the long run inflation rate.”  While the higher prices for gasoline and food can lead to inflation, it is more likely that these prices will stabilize, albeit at higher levels, and consumers will make substitutions in other areas of their lives to offset the increased costs of food and gas.  In order for inflation to take hold, price increases would need to be sustained across all goods and services.

The most accurate predictor of future inflation increases in our economy is wages.  Respected economist David Rosenberg has commented recently that “unit labor costs have historically had an 80% correlation with inflation, and those costs are declining.”  When wages begin rising and are sustained at higher levels, then inflation can take hold.  Wages, however, do not rise when unemployment levels are high.  The sad news for the US economy is that through May of 2011, the official unemployment rate continues to hover around 9%.  More depressing is that the broader measure of unemployment, which includes people who stopped looking for work and those who settled for part-time jobs, has recently been as high as 16%!  New York Federal Reserve Bank President William Dudley estimates that the unemployment rate would have to fall to 6% to 7% in order for inflationary pressures to build.

Unemployment levels are unlikely to fall quickly given the rate of growth of the U. S. Economy.  On June 7, 2011, Federal Reserve Chairman Ben Bernanke spoke at a conference in Atlanta, Georgia, where he indicated that US economic growth so far this year was somewhat slower than expected.  The economy will need to start growing at a much more rapid rate than it is currently in order to reduce the unemployment levels.

Bernanke went on to say that there are two major factors that will limit inflation in the near-term.  First, the substantial slack in U.S. labor and product markets will have a moderating effect on inflationary pressures.  The second factor restraining inflation is the stability of longer-term inflation expectations.

Despite the recent run-up in many commodity prices, there is little concern that long-term prices will be sustained at higher levels.  In addition to these fundamental reasons why inflation will remain benign, the Federal Reserve is on record as being prepared to “take whatever actions are necessary to keep inflation well-controlled.”  Therefore, inflation should not be a near-term concern.

Assuming we are in a sustained low-inflation environment for the next 18-24 months, what are the investment implications?  We need to start by reducing our expectations and accepting that lower investment returns will likely be the norm for the next couple of years.  PIMCO, the large bond management firm, has deemed this lower-return investment environment “the new normal.”

An environment with little risk of sustained inflation makes bonds more attractive on a relative basis.  Low inflation periods limit the upside for commodities.  Cash, as we have experienced recently, provides almost no investment return when inflation is very low.  Stocks, which benefit from lower inflation and low interest rates, are hindered by a slower growing economy.  In summary, there are no asset classes that are poised to outperform in the current environment which makes diversification even more important.

Despite the fact that we may have to accept lower returns, there are several portfolio modifications that can be made to better position portfolios in this economic environment.  One involves pursuing higher yields on bonds without incurring significant additional risk.  PIMCO has been repositioning its mutual funds to do this.  In addition, we are looking to add new investments in portfolios that will increase bond diversification to help mitigate risk.  Another portfolio adjustment is increasing the exposure to the rapidly-growing emerging economies in the international equity markets (e.g. Brazil, India, and China) relative to the slower-growing, more fiscally challenged developed country markets (e.g. Japan and the United Kingdom).  The final change is to add non-correlated investments to the portfolio.  By increasing portfolio diversification with non-correlated investments, we minimize the likelihood of a major decrease in wealth if one or more investment markets suffer a near-term decline.

While we wait for stronger economic growth domestically and globally, Oak Wealth Advisors wants to capture as much return as possible given each investor’s tolerance for investment risk.

This update is intended for the use of Oak Wealth Advisors LLC clients. This update should not be viewed as personalized investment or financial planning advice from Oak Wealth Advisors LLC. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to their individual situation, they are encouraged to consult Oak Wealth Advisors LLC. Past performance does not guarantee future results and all investments should be scrutinized before being implemented in a portfolio.