CHICAGO — Inflation affects us all. Even when it is coasting along at what might seem to be a harmless rate, it eats away at the buying power of the dollar.
When inflation hits 11% as it did in 1979, and then rises to 13.5% as it did in 1980, the world of investing, saving and spending is turned upside-down. That’s why some financial professionals are concerned about the most recent trend. After finishing 2010 at an average rate of 1.6%, the first five months of this year show an average of 2.64%, with the latest month in that period hitting the 3.6% mark.
Could this be the portent of sky-high inflation such as we saw in the 1970s? There is a growing amount of evidence that would suggest that possibility. The chief villain, according to many economists, is the Federal Reserve’s easy-money policy designed to support the government’s $2.2 trillion in stimulus spending. That, in addition to the rise in other government spending, has skyrocketed our federal debt.
With too much money chasing after too few goods and services, the inevitable result is a rise in prices of those goods and services. Another problematic issue is the formula used to officially establish the inflation rate, which does not include the cost of food and energy—two of the most rapidly rising expenses in the typical consumer’s budget.
According to one of the so-called gloom and doomers, the worst is yet to come. “We are talking hyperinflation of the likes we haven’t seen in this country since the Civil War when the Confederate currency hyperinflated as the Union won the war,” he says.
But opposite points of view are easy to find. Michael Dueker, chief economist at Russell Investments, is far less concerned about the near-term risk of a harmful and long-term spell of inflation. Writing in Kiplinger’s Personal Finance Magazine, he says, “The Fed’s balance sheet will shrink when our economy strengthens, and the Fed will rein in the extra cash to head off inflation.”
So what is the average saver/investor to do? One possibility is to assume that these opposing views will cancel each other out, resulting in a middle-of-the-road scenario with inflation leveling off at a rate in line with long-term averages. Even if that proves to be correct, the effects of inflation on our personal and business finances must be taken into consideration.
Throughout our long history, inflation to one degree or another has almost always been with us. That’s why it may be important to hedge our bets. One way to protect against a rise in inflation is to invest part of your portfolio in Treasury Inflation-Protected Securities (TIPS).
TIPS are government-issued bonds that, like their counterpart I-Bonds, provide a hedge against inflation. TIPS set their interest rates when they are sold. However, the bond’s underlying principal rises and falls with changes in the inflation rate, so, as the rate moves up or down, the amount you will receive as interest also changes. You will always get at least the par value of the bond when you redeem it.
Interest is paid out semiannually. When the bond matures, your final principal value is adjusted for inflation during the term of the bond.
Like I-Bonds, TIPS are guaranteed by the U.S. government and are exempt from state and local tax. Unlike I-Bonds, Uncle Sam is going to tax you at ordinary income rates for the semiannual interest payments you receive, as well as on the “phantom income” you receive as your underlying principal adjusts for inflation.
Predicting the future in our volatile economy is a problematic task to say the least. However, if you share the concern that the inflation rate is likely to rise, you may want to consider adding TIPS or I-Bonds to your investment portfolio.
For more information about TIPS and I-Bonds, log on to treasurydirect.gov.
Information in this article is provided for educational and reference purposes only. It is not intended to provide specific advice or individual recommendations. Consult an accountant or tax adviser for advice regarding your particular situation.