Imagine you are the chair of the Federal Reserve, Ben Bernanke.
You've already made a decision to expand your efforts beyond fighting inflation and have decided to enact a controversial policy of leveraged stimulus. Critics abound but you press forward with seemingly positive results. Economic growth continue recovers and financial stability is better than it has been in years (at least for the short term). You've made pledges to keep interest rates low for two years until 2014 and that has provide a level of stability as market participants have an indication of what interest rate policy might be in the future.
But then a bump in the road suddenly appears; energy prices spike and economic growth returns. The unemployment rate, while stubbornly high, falls to 8.3%. And now you are faced with the specter of how to unwind an interest-rate policy that has largely been focused on economic stability, rather than fighting inflation. Now what?
It's no wonder that companies (and not just Apple ) are hoarding cash as they continue to be cautious about the future. We are in unprecedented times regarding the direction of the economy. With the troubles in Europe only calming down, not going away permanently, corporations are hesitant to spend cash to stimulate real economic growth. And as China continues to slow down, the global economic picture remains murky. What would YOU do if you were a CFO? Perhaps hoard cash given these uncertain times? I bet you'd be tempted.
Clearly, we are in an unprecedented time in economic history of the United States. And the Federal Reserve stands as the activist institution holding the strings to the future of economic recovery. With a gridlocked Congress and an election-year focused more on rhetoric than solutions, the world looks to the Federal Reserve for its next policy move.
But is there absolute clarity about future action from the Federal Reserve? Of course not. A recent Federal Reserve Governor speech indicated that while the 2014 pledge is the current policy of the Federal Reserve, that pledge could be modified if economic growth significantly rises to the level that suggests inflation may become damaging to the economy. I appreciate the flexibility, but it is important that one recognizes that the “pledge” by the Federal Reserve is as guaranteed as political rhetoric. A pledge is clearly merely a target and NOT a promise. For that reason, one should be diligent in assessing Federal Reserve action.
We've been concerned about inflation for quite some time. True, this has been an overly cautious perspective over the last year, but we think the reasons for this viewpoint had merit. And with oil prices now above $100 per barrel, employment seeming to pick up, and a spend happy Congress willing to mortgage our future with deficit spending, it's hard not to adopt a perspective that inflation could very well accelerate.
In fact, inflation may be here already. When assessing inflation, it all depends on the index that you examine whether inflation is here or not. While CPI and PPI are normally the quoted measures for inflation, the American Institute for Economic Research has developed an index called the EPI (Everyday Price Index). According to this index, the current inflation rate is closer to 8% rather than 3%. As with all index measurements, one must assess the inherent bias in any statistic and this index is no exception. But for many Americans, this index FEELS more accurate as food and gas rise through the roof.
Here's the investment issue for you. If an expectation of rising inflation gathers steam, this tends to fuel a self-perpetuating economic condition. And as oil prices percolate through the economic system, it's entirely possible (and becoming more feasible) that rates might rise faster than many expect. More importantly, the fixed income market might anticipate rates rising and bid down the prices of longer duration fixed income assets.
So as you invest, consider rising inflation as a real possibility. The economy is recovering. We believe that the increase in GDP and the falling unemployment rate is the beginning of a trend rather than a one-time pop in economic activity. And if this thesis plays out, recognize it will have investment consequences for you as an investor. Keep that in mind as you develop portfolio strategy going into 2012.
And importantly, make your own decision on where you believe interest rates are headed. And if you believe they are headed higher, make sure that your fixed income strategy is duration appropriate so you are not ambushed if the so-called "pledge" turns into merely a one-time target abandoned in the face of rising inflation.
Remember, a pledge is not a promise.
Michael Yoshikami, Ph.D., CFP®, is CEO, Founder and Chairman of the DWM Investment Committee at Destination Wealth Management. Michael is a CNBC Contributor and appears regularly on the network. DWM is a San Francisco Bay Area-based independent money management firm that provides fee-based wealth management services to institutions and individuals around the world. Michael was named by Barron's as one of the Top 100 Independent Financial Advisors for 2009, 2010 and 2011.