Many investors have concerns about the potential inflationary impact of the government’s current fiscal and monetary policy.  Although expansion of the money supply can often lead to inflation pressures, comments from Federal Reserve officials and a review of the broad measures and drivers of inflation indicate that another potential (and possibly bigger) risk in the near and intermediate term is deflation. Let’s begin by defining the terms used to describe the behavior of prices and also pointing out that the United States has experienced all of these environments at various times in its history:

• Inflation: an increase in the overall price level over a period of time
• Deflation: the opposite, a decline in the price level
  • Deflation typically occurs with economic downturns. The two severe periods of deflation occurred during the depression eras of the 1890s and 1930s.  We also experienced a short deflationary period at the heart of the credit crisis in late 2008 to early 2009.
• Disinflation: a period when inflation is positive, but declining over time
  • The U.S. had a relatively long (albeit uneven) period of disinflation from spring of 1980 to summer of 2002. Inflation peaked (on a year-over-year basis) at 14.6 percent in April of 1980 and declined (in an uneven pattern) to 1.07 percent in June of 2002.

Why do we suggest that deflation is a risk in the current environment?
From a broad perspective the U.S. economy still has significant excess capacity, as demonstrated by low capacity utilization rates coupled with high unemployment. Despite aggressive monetary policy (the Fed “printing money”) and the expansion of the monetary base, banks aren’t lending money, consumers are paying down debt and the savings rate is increasing. Globally, austerity measures designed to cope with high levels of debt (such as in Greece) are also deflationary. These countries must lower expenses by reducing wages, laying off workers and reducing pension guarantees—all deflationary forces.

Will the U.S. suffer the fate of Japan, which has been mired in a deflationary slump since the 1990s?
In our opinion, it is unlikely. The aggressive fiscal policy and easy monetary policy currently in place are designed to offset deflationary factors.  As a student of the Great Depression, Ben Bernanke (current Fed chairman) makes decisions designed to avoid the policy mistakes of that era and previous economic crises both here and abroad.  Current U.S. policies also differ from the disjointed strategy employed in Japan that resulted in the ‘lost decade’ for the Japanese economy.

What about the risk of inflation?
At present, we view significant inflation risk as low. Inflation expectations (as measured by the Treasury Inflation-Protected Securities (TIPS) market) are low, and the inflation data itself is decelerating. ‘Gold bugs’ might argue otherwise, but we would assert that recent gold strength is more reflective of concerns of financial instability rather than inflation. Inflation could potentially become a problem if the Fed continues to pursue current policies while the economy recovers, capacity becomes tight and the unemployment rate declines significantly. Those conditions are not expected in the near future.

Periods of deflation and disinflation/low inflation favor income oriented investments.
In an environment where cash yields little, a portfolio of high-quality, intermediate-term bonds should offer investors an attractive compromise in terms of yield and mitigation of market (interest rate) risk.  A temptation in these low interest rate conditions is to extend maturities in order to improve fixed income yields.  We continue to advocate the intermediate laddering of high-quality bonds as a way to reduce the interest rate risk.

Equity and Growth Strategy
In terms of equities, our managers emphasize the quality of companies’ balance sheets (important in this environment).  Additionally, our recommended allocation to large-cap equities and real estate (real estate investment trusts) provides the opportunity for attractive dividend and dividend-growth opportunities.