Dr. Wood, can you briefly explain current Fed Policy?
Since 2008, the Federal Reserve has been pursuing what I call an "ABD" policy — or "Anything But Deflation." Basically, the Fed has worked hard to avoid a Japan-like scenario¹. Even though the odds of deflation continue to drop, its consequences would be catastrophic. So think of Quantitative Easing (QE) 2² as a $600 billion insurance policy that the Fed took out to insure against deflation. While inflation always needs to be a concern for an investor, we see any significant inflation occurring in terms of years, not months.
Thanks for that. What is Russell's current outlook on inflation in U.S. markets?
Perhaps most interestingly, readers should know that we do not see a high probability of that late-1970s style of inflation — which I believe is most people's fear. At Russell we expect that, while inflation expectations have risen in recent months, inflation itself will continue to be tepid in 2011. If you look at breakeven rates (or the market expectation of inflation) it takes about six years for inflation to pierce the Fed's stated target of a 2% ceiling.
U.S. inflation breakeven rates
Essentially, we�ve moved from fears of deflation to concerns over modest inflation — and that (believe it or not) is an improvement. For the rest of 2011, Russell believes it's a safe bet that the Fed will continue to worry equally about deflation and runaway inflation.
Why is the Fed trying to create some inflation?
Reasonable inflation is seen as "better" because it changes behavior. For example, if investors and consumers expect modest car price increases, consumers are more likely to buy a new car now when it's comparatively cheaper — and investors are more likely to invest in car companies given increasing demand. If you think that housing and land costs will rise, then you're more likely to invest in real estate. If you assume prices will drop, then you'll probably hang onto your money. Markets want money to move. A reasonable amount of inflation makes money move and spurs investing. So the Fed is working to lower funding costs and to push inflation expectations (and thus behavior) positive — as part of that "A.B.D." policy.
In your opinion, what's keeping inflation in check?
First, the historic shock to the world financial system in 2008 caused everybody (every person every household, every business, and every government) to have a higher demand to hold cash than they did three years ago. Recent studies have shown that in the US alone, the global financial crisis caused over $1.3trillion in losses and write-down's. (Europe has confessed to about $550 billion, but trust me, that European number is going spike — and a lot.) This has chewed up a lot of capital, and the Fed has had to replace that chewed up capital trying to fill that massive hole.
Look at the velocity of money — the rate at which money in circulation is used for purchasing goods and services. It is still at multi-year lows and all that "printed money" is just sitting there.
Velocity of money - United States
Second, there is also an "output gap" that is still yawning — meaning that our economy is not operating anywhere near full efficiency. Jobs are still relatively scarce and wages aren't growing very fast, so there's just not enough demand for goods for companies to be reasonably able to raise prices.
Output gap and inflation - United States (3/31/86 - 12/31/10)
While Russell is acutely aware of the consequences of high inflation -mostly because wages don't rise as quickly as prices — right now we don't see the case for runaway inflation as a near-term threat.
Dr. Wood, what's the outlook on inflation mean for markets and investors?
As we said in our 2011 Outlook, Russell expects the risk of inflation in the U.S. to remain relatively benign. We think the Fed's late-2010 quantitative easing will succeed in avoiding deflation. And with deflation mostly off the table, we also expect that core bond markets will experience a mild sell-off — the key word being mild. We project that 10-year treasuries will have a 3.8-4.0%% yield. On the equity side, we expect 2011 returns in the high single digits to low double digits. And, if inflation continues to remain low, traditional inflation hedges such as commodities and real assets may be less appealing in the short term.
But look, none of this is a sure thing — especially in the short term. That is why at Russell we always preach broad diversification across all asset classes and styles. The best protection against inflation, deflation, stagflation or stagnation is a well-diversified, well-managed portfolio.