What Investors, Consumers and Retirees Need to Do Now

The prices of cotton and corn have more than doubled in the past year. Sugar is up 60% and wheat, 55%. Silver prices have gained more than 50% and copper, 36%. At the gas pump, it costs 30% more to fill up than it did one year ago. But the Federal Reserve insists that inflation is under control and that sky-high commodity prices won’t derail the economic recovery.

The inflation outlook is critical to you both as a consumer and an investor. Bottom Line/Personal asked Irwin Kellner, PhD, one of the nation’s most respected economists, about the inflation time bomb we’re seeing down the road and how it’s likely to affect you…

Why have food and energy prices risen so sharply?

The trend has been driven by a “perfect storm” of factors — political unrest in the Middle East has led to spiking crude oil prices… violent weather patterns, including floods in Australia and drought in China, have decreased the global crop supply… recovering economies have increased worldwide demand… plus our own government has set the stage for higher prices. Since 2008, the US Federal Reserve has kept short-term interest rates near zero and purchased hundreds of billions of dollars’ worth of US Treasury bonds, flooding the economy with money in an effort to stimulate economic growth and reduce unemployment. The idea is that businesses will borrow, expand and hire more people when money is cheap — and that investors will favor stocks as interest rates remain low, helping extend the stock market recovery and thereby bolstering the economy.

In many ways, inflation has been climbing more visibly overseas in fast-growing economies such as China and Brazil, but it’s arrived here, too, as more companies that were resistant to passing along higher expenses to consumers now are doing so. The Consumer Price Index (CPI) rose by 2.7% over the past year, still below the historical average of 3.4% but high enough to be worrisome.

What are some examples of consumer price jumps?

US energy prices rose by 3.4% this past February alone, and another 3.5% in March. Partially as a result of rising fuel prices, airline prices have surged. Food prices at the wholesale level rose by the most in 36 years, and restaurant menu prices are climbing. Chocolate bars, cereals, cold cuts, ice cream, tuna and even ketchup, toilet paper and spices such as garlic powder and black pepper have jumped in price or their package sizes have shrunk.

Among other examples, Hasbro and Mattel have said that they are raising toy prices, and Whirlpool and Electrolux are planning to raise appliance prices. Underwear makers are even looking for alternatives to cotton, whose price has soared. Many manufacturers have raised prices in a stealthy fashion — for example, bars of Dial soap now have a contoured pinch in the middle. The company says it is to make the bars easier to hold, but in reality, you’re getting 10% less product for the same price.

So why does the Federal Reserve keep saying that inflation is not a major worry at this time?

The main goal of the nation’s central bank right now is to make sure that the economy keeps gaining strength and that unemployment drops — and to worry about soaring prices later — so it plays a game of semantics. Even though inflation is up, the Federal Reserve uses a special statistic, known as the Core Consumer Price Index, which doesn’t include prices of food and energy, to decide when to raise interest rates. Government economists have decided that these goods, including orange juice and gasoline, fluctuate in price so much that it would be foolish to consider policy changes every time their prices bounce up or down. What the Federal Reserve doesn’t seem to get is how much even modest inflation hurts the average person now. Almost everyone is feeling pinched because personal income has stagnated nationally. Back in the 1980s, the last time we had significant inflation, unions were much stronger and more pervasive and most workers could demand inflation-beating wage growth. That’s not true today.

Meanwhile, the Federal Reserve’s efforts to save the economy with cheap money has been worth billions of dollars to banks and mortgage borrowers, but it’s been brutal for savers and retirees living on fixed incomes who are hurt by low interest rates. Social Security recipients have gone two straight years with no increase in cost-of-living benefits. The yields on cash in money-market funds have been near zero, and a six-month certificate of deposit (CD) yields a national average of just 0.29%.

When will inflation really hit us, and how bad could it get?

If Federal Reserve Chairman Ben Bernanke makes all the right moves at the right time, the economy’s growth will accelerate and annual inflation will be around 2%. Congress will be able to pare the budget deficit, and Bernanke will be able to wait until after the presidential election in 2012 or beyond to slowly start raising interest rates.

But that kind of Cinderella outcome isn’t likely. In failing to address inflation now — at least by signaling when the Federal Reserve might raise rates — Bernanke will cause injurious effects down the line. I expect inflation to pick up in the second half of 2011 when a lot of the government stimulus programs cease. Recently, the CEO of Wal-Mart said that “serious” inflation will likely “start hitting consumers in their wallets this summer.” And in a recent poll of US money managers by Barron’s, 57% predict inflation will pose a risk to the economy in the next 12 months.

By the end of this year, inflation could be running 4% to 5%, and the Federal Reserve might have to raise interest rates aggressively to slow it down. Since higher rates work slowly to mitigate the effects of inflation, we may see much higher prices for the next few years.

On the other hand, I don’t think that we will experience the kind of hyperinflation that we saw in the 1970s and early 1980s, when prices were rising by as much as 13% a year and interest rates on money-market accounts went even higher. Back then, workers’ wages kept pace with the rise in inflation, which, in turn, led to continued consumer spending and higher and higher price increases. In today’s economy, consumers simply will cut back and stop spending if prices rise that sharply.

With higher inflation on the horizon, what should investors be doing?

If you have a diversified stock-and-bond portfolio, you probably just need to tweak your asset allocations rather than overhaul them. Cut back on US Treasuries and long-term bonds, whose prices will fall even in advance of interest rates rising. Avoid locking into CDs for longer than six months or a year, and certainly not three or five years, because the rates available in 2012 will almost surely be more attractive than today’s. I think it’s wise now for the typical investor to tilt his/her portfolio toward stocks and commodities, which tend to do well in inflationary environments, but neither asset class is really cheap now. So you are better off waiting until bargains are more readily available.

What should retirees do?

Retirees who want to keep pace with inflation while avoiding risks should consider two types of government securities — Treasury Inflation-Protected Securities (TIPS), available in five-, 10- and 30-year denominations… and 30-year Series I Savings Bonds (I-Bonds). TIPS, whose principal is adjusted for inflation, currently yield 1.69% annually. I-Bonds, which have both a fixed rate and a variable rate adjusted twice a year for inflation, currently pay 4.6%. Their interest is exempt from state and local taxes, and investors can defer federal taxes on the interest until the bonds are cashed in. You must wait at least 12 months before redeeming I-Bonds…you can buy up to $5,000 worth in each calendar year… and if you sell them before five years, you forfeit interest from the three most recent months. You can buy TIPS and I-Bonds at www.TreasuryDirect.gov.

What about short-term savings?

Long-suffering savers who keep cash in money-market funds, savings accounts and CDs will get better yields as the Fed raises rates — possibly by later this year — to counter inflation.

How will all this affect real estate?

Inflation hasn’t hit the real estate market yet. A combination of an oversupply of homes, a relentless wave of foreclosures and a shift in psychology among potential buyers has kept prices low. Thirty-year mortgage rates still are well under 5%. (They were more than 18% back in 1981!) My rule of thumb for real estate: When the nationwide median home price is less than three times median household income, it’s a good time to buy. Right now, it’s 2.7 times — the lowest ratio since the 1980s, so it may be time to buy.

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