Predicting Inflation: Portfolio Erosion or Collapse?

Abstract

What is the probability of high inflation; how high, when? These questions are important to all investors since even the 2% level to which we are accustomed will cut an investor’s portfolio by over 17% during a decade. This 2% level is the target of the Federal Reserve, along with near 0% interest rates, for a risk free rate of -2%. This guarantees portfolio erosion absent risk-taking, which could result in even lower returns if the risks of loss are realized. An AARP article characterizes this as The War On Savers. Higher inflation is possible, at 4% or more, with even worse effects. There are heated debates about the probability and timing of high inflation, but our review of the extensive literature reveals no reliable way to predict its onset or extent. Expert opinion predicts inflation best, but it has failed to predict the onset or extent of inflation, and past inflation predicts the experts’ estimates as well as the experts predict future inflation. Debt levels are very high, and inflation is one of the possibilities for deleveraging. The Japanese have proved that high debt can exist without inflation for at least a decade or two, at least in their particular circumstances. Our high debt levels are partly due to the housing collapse. We propose months of unsold housing inventory as an indicator likely to decline before a sustained housing rally, and shelter is both the largest single component of inflation and affects consumer wealth and psychology. We also propose that portfolio erosion through 2% inflation is likely to continue for the present, and that much higher inflation is unlikely until the economy strengthens, but that it remains a risk until deleveraging has occurred by some other means. We suggest monitoring banks’ Federal Reserve deposit levels, which are reported weekly, as another barometer of inflation risk. A portfolio invested in traditional liquid assets – stocks, bonds, and cash – is unlikely to weather high inflation intact; the extent of the damage to each of these asset categories varies widely among inflationary periods and is volatile within these periods.