Investing: Keeping Inflation at Bay

After decades in remission, inflation is making a comeback. Rising prices already are making consumers miserable and squeezing corporate profits, but inflation also might cripple investors' returns if they're not careful.

It's not yet clear that higher inflation is here to stay, but there's no doubt the price of many basic materials—notably fuel and food—are skyrocketing. Once firmly established, inflation will be hard to dispel, and that worries economists, investors, and the central bankers who set interest rates around the world.

There are investing strategies that can protect portfolios from inflation—some of which we describe below—but few investors can fully escape inflation's destructive influence on the economy and financial markets.

A Sinister Beast Uncaged

Richard Fisher, president of the Federal Reserve Bank of Dallas, gave a sense of how much the Fed worries about inflation in a May 28 speech. "Inflation," Fisher said, "is a sinister beast that, if uncaged, devours savings, erodes consumer purchasing power, decimates returns on capital, undermines reliability of financial accounting, distracts the attention of corporate management, undercuts employment growth and real wages, and debases the currency."

And those aren't the only troubles inflation brings. The cure for inflation, hikes in interest rates, can be worse than the problem. Higher lending costs could not only slow down a weak economy, but also exacerbate the U.S. housing crisis.

Although there are things investors can do to prepare for inflation, few are certain to counteract its effects. That's worrisome because evidence of inflation is everywhere lately.

Dow Chemical (DOW) raised product prices by up to 20% on June 1, after executives said the firm's bill for energy and feedstock jumped 42% from the year before.

April's U.S. consumer price index, a measure of all consumer costs, was up 3.9% from a year ago, with energy costs higher by 15.9% and food up 5.1%. The Fed recently revised its 2008 inflation expectations to a range of 3.1 to 3.4%, up a full percentage point from the beginning of the year. According to the Reuters/University of Michigan Surveys of Consumers, Americans in May said they expected the highest levels of inflation in more than two decades.

And it's not just a U.S. worry: European central bankers have not cut interest rates, held back by inflation concerns, and many emerging economies are seeing costs rise, too.

The U.S. economy seemed to slow at the beginning of the year, a trend many thought would stifle inflation, says John Merrill, chief investment officer at Tanglewood Capital Management. "In fact, inflation seems to be building," he says.

Strong Demand Is Buoying Prices

"The global economy remains very strong," meaning demand for natural resources is strong, too, says Susan Perkins, managing director at Provident Investment Counsel. That has pushed the price of energy and other commodities to record levels. Average gas prices are at $4 per gallon nationwide, and the price of oil hit $135 per barrel in late May before backing off recently.

Despite the worries, high inflation isn't a certainty. The yield on a two-year Treasury note is still a low 2.5%, suggesting bond traders don't expect a major spike in inflation. What could prevent inflation? A weak economy crimping demand for goods and services, for one thing. Also, Brian Gendreau of ING Investment Management (ING) notes that up to three-quarters of corporate costs go toward labor, and wages are actually falling by some measures.

If inflation does spike, it presents a dilemma for investors. Government bond yields are likely to rise along with inflation, while the value of bonds in a portfolio could plunge. Putting all your money in cash might be tempting, but inflation will hurt the buying power of that cash.