Inflation used to be the biggest threat that investors faced, as its inexorable erosion of purchasing power hit even those who thought their investment portfolios were growing. In recent years, though, inflation hasn't been a threat at all, and policymakers seem more concerned about the prospect of falling prices. Even as traditional inflation-fighting investments SPDR Gold Trust (NYSEMKT: GLD ) and iShares Barclays TIPS Bond (NYSEMKT: TIP ) have fallen out of favor lately, is inflation dead for good or should contrarian investors prepare themselves for its potential return in 2014 and beyond?
Why inflation hasn't reared its ugly head -- yet
The most surprising thing about inflation's absence lately is that low prices have defied every effort among policymakers to push them up. Federal Reserve Chairman Ben Bernanke has noted the importance of making sure inflation rates don't fall too far below the targeted goal of 2%, saying the Personal Consumption Expenditures price index is currently too low at just above 1%. Chicago Fed President Charles Evans said earlier this year that he supported continuing quantitative easing at full force as long as inflation remains below target.
Yet despite those efforts to keep inflation up, prices have remained stubbornly stable. The Consumer Price Index has only risen by 1.2% over the past year, with most spending categories having stayed largely in check. Food prices have risen just 1.4%, while energy prices have actually dropped more than 3% due largely to a 7.5% decline in gasoline prices year over year. Yet even traditionally higher-inflation areas have had restrained growth, with medical-care services rising only 3.1%.
One common explanation for the lack of inflationary impact from the Fed's moves is that banks haven't taken the resulting liquidity and put it to work making loans. Indeed, the move away from banks actually keeping loans on their books has led Wells Fargo (NYSE: WFC ) , Bank of America (NYSE: BAC ) , and other financial giants to become much less important as direct lenders and more important as facilitators to connect borrowers with asset-backed-securities investors. Many would-be borrowers look at what B of A and Wells Fargo have done as a breach of good faith after the bailouts they received, but much of what's at fault is the current system that promotes securitization in the first place.
In addition, the impact on markets from lower inflationary expectations has in some ways created a downward spiral that discourages future inflationary pressures as well. For instance, gold prices have plunged as fears about inflation have removed its perceived value as a hedge against higher prices. Investors have fled from SPDR Gold Trust and other gold-related investments, and the resulting lack of interest in commodities more broadly has pushed prices down across the sector, further contributing to the lack of pricing pressure.
Where inflation in 2014 could come from
Looking at market expectations for inflation in 2014, no one seems particularly worried. One-year Treasury Inflation-Protected Securities of the same type that iShares Barclays TIPS Bond holds are priced to yield a negative real interest rate of -1%. Compared to standard bonds, that implies an inflation rate that matches the current 1.2% backward-looking figure.
Yet policymakers appear almost too willing to accept inflationary risk in their struggle to get the economy moving forward. Janet Yellen, who stands in line to take over as Fed Chair early next year, told Congress that she sees no evidence that quantitative easing has distorted asset prices, quelling fears among some investors that markets are reaching bubble-like levels. Yellen sees even the large rises in real-estate prices in some areas as merely being a natural recovery from the huge drops they saw during the housing bust, and she pointed to fairly restrained earnings multiples on stocks as evidence that no bubble is imminent.
A few signs of bottoming prices have also lent credibility to the idea that inflationary pressures could arise. After years of rock-bottom levels, the Baltic Dry Index has started to recover, and that has helped support DryShips (NASDAQ: DRYS ) and other shipping companies. Even with recent gains, DryShips and its peers could use further increases in order to become sustainably profitable. If the prices DryShips and other shippers charge continue to rise, it could in turn boost prices for imported goods around the world, undoing some of the benefits that consumers enjoyed from cheap shipping since the financial crisis.
Be careful what you wish for
Still, the likelihood is that inflation in 2014 will remain at the same muted levels investors have enjoyed for several years running. Indeed, as Europe struggles with the same deflationary pressures that the U.S. has faced, central banks around the world might end up getting even more aggressive in trying to keep prices up. That might not hurt investors in 2014, but further into the future, policymakers will have to be careful to avoid pumping up prices for too long a period.
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