A recent column in the Wall Street Journal notes that, while inflation may see a near-term increase, this will be temporary in nature since it will be measured against the depths of the recession, when prices dropped sharply across the board. As the Journal puts it – “this baseline effect will only be temporary and won’t faze the Fed.” In other words, while a temporary increase in inflation may add fuel to inflationary expectations, and perhaps get the futures market to price in more hikes earlier in the year, all the Fed will see is inflation expectations that are well anchored, an inflation trend that remains weak, and an unemployment rate that remains high. Going forward, a weaker labor market can keep inflation in check, since employee compensation accounts for roughly 30% of US production costs while commodities account for just over 2% of production costs. This lends weight to the expectation that inflation will possibly trend upward by the end of the year, but then steadily decline through 2010. If this holds true, expect the Fed to remain on hold for the duration of 2010.
What does this all mean for fixed income investors who are convinced that inflation is looming on the horizon? Clearly, the high after-tax returns offered by municipal bonds make them an effective inflation hedge. If one believes that the current economic stimulus will lead to higher inflation, higher interest rates will also likely ensue. Shorter maturity municipal bonds will outperform longer maturity municipal bonds in this type of environment. However, predicting the future movement of interest rates is an imperfect, if not impossible, science. Therefore, despite inflation fears, a prudent strategy is to invest at least a portion of your portfolio in longer maturities to hedge against milder inflation and interest rate scenarios.