Morningstar | Is the inflation threat hype or real?

This article from Morningstar provides some good insight into the current inflation issues.  Below is an excerpt from the begining of the artice. that hits the highlights.  If inflation rises, it is important to be fully invested and be careful with fixed income duration.

Is the inflation threat hype or real?

Concerns have been raised that the US government’s attempts to stimulate the economy could unleash a wave of runaway inflation. Is inflation in the future—and if it is, is your portfolio prepared for one of the greatest risks to personal wealth?

Many economists will tell you not to worry about inflation. While the consumer price index (CPI), a widely used gauge of consumer spending, rose 0.5% in December 2010, its largest monthly gain since June 2009, so-called core inflation (which eliminates volatile food and energy costs) was a relatively weak 0.1%. For 2010, the CPI rose just 1.5% and core inflation rose only 0.8%. That places core inflation well below the US Federal Reserve Board’s (Fed’s) target of 2%— and the 2% to 2.5% annualized rates prevailing before the Great Recession of 2008 and 2009.

Many inflation watchers argue that the downtrend does not seem to have ended. They point out that with the unemployment rate at 9.4% as of December 2010, wages are going to stay low for a long time, which will help rein in inflation. If anything, these economists say, slack in the labor markets suggests that core inflation might continue to fall for awhile.

Many investors agree. Consider the bond market: The 10-year Treasury note was yielding just 3.43% as of 1/24/11, according to the Federal Reserve. At the same time, traditional hedges against inflation—Treasury inflation protected securities (TIPS) and gold—have recently fallen in price, according to the Barclays Capital US TIPS Index and Dow Jones US Gold Mining Index.

But there are three reasons we call inflation “the phantom menace”—meaning you need to be aware of it.

Rethinking Inflation: Three reasons we call inflation the phantom menace

Official Inflation Data May Be Understated

Over the past 30 years, the government has made many changes to the way it calculates inflation. Because of these changes, inflation today may not be the same thing as inflation the last time we saw it.

According to economist John Williams at Shadow Government Statistics, if we still calculated inflation the way we did under the Carter presidency, today’s CPI would be closer to 10% than 1.5%. Jim Grant, the host and editor of the newsletter Grant’s Interest Rate Observer, has said that the Fed arguing that the inflation rate is too low is “like the New York Police Department complaining about the lack of crimes.”

How can this be the case? The way inflation is calculated today, if steak prices boom, it’s assumed that you will buy cheaper hamburger instead—making inflation nonexistent.

Or, consider the case of hedonics, which is a method of estimating a product’s value. Hedonics asks the question, "How much of a product's price increase is a function of inflation, and how much is a function of quality improvement?” Let’s say, for example, that you purchase a television. The quality of televisions has increased over time, with many improved features, such as plasma screens and HDMI connections. If you buy a more expensive TV today, then, is that the result of inflation? The government says no—and uses a complex calculation to adjust inflation for product quality enhancements. Its argument: In a way, the price of the improved TV is going down, not up, because you’re getting more for your money.

On the following pages, we look more deeply into the history, evolution and current composition of the CPI.

Official Inflation Data Looks Backward

Inflation numbers calculate what has happened, not what is going to happen. But if you look beyond labor costs and consider raw materials, you’ll see that prices are rising. Consider a 10/21/10 article in The Wall Street Journal, “Dilemma Over Pricing,” which points out what is obvious to anyone who follows commodities: The cost of nearly everything is going up. As the article notes: “Corn is up 44%, milk is up 6.5%, hot rolled coil steel is up 4%, copper is up 29% and oil is up 14% from a year ago.”

Sooner or later, these raw material price increases are going to show up in consumer goods. “Across Corporate America, more companies are wrestling with when and how much to raise prices as raw materials costs climb,” says The Wall Street Journal article.

In fact, prices may already be rising. “There might not have been a second round of quantitative easing if Federal Reserve Chairman Ben Bernanke shopped at Walmart,” says a 1/11/10 CNBC.com article. “A new pricing survey of products sold at the world’s largest retailer showed a 0.6% price increase in just the last two months, according to MKM Partners. At that rate, prices would be close to 4% higher a year from now, double the Fed’s mandate.”

And it’s just not Walmart that is raising prices. MKM surveyed 86 everyday grocery items such as food and detergent made by national brands, and found a “meaningful increase.”

Economics 101

The Fed, in an attempt to stimulate the US economy, has engaged in another round of quantitative easing. This easing, dubbed QE2, would involve massive purchases of US Treasuries—which is designed to push down yields on Treasuries and bonds and drive up investment and consumption.

There are many fancy names for what the Fed is doing, but essentially, the policymakers are creating more money—and in doing so, diluting the purchasing power of the dollar.

What the economy needs, the Fed’s thinking goes, is some inflation. Indeed, according to some insiders, the Fed is seeking an inflation rate in the 4% to 6% range for just “a couple of years”—but if this spills over into 1970s-style double-digit inflation, then so be it.

“That’s because the central thinking at the Fed is that while it knows how to deal with inflation and recognizes the problems associated with fairly high rates of price appreciation, embedded deflation is…harder to defeat,” says a 10/14/10 article in The Wall Street Journal, “Choosing the 1970s Over the 1930s.”