Inflation Rates Keep Falling: How Long Can It Last?

Economists and market watchers have been warning investors about the prospect of increased inflation since the housing bubble burst in 2007. But the inflation rate keeps going lower, not higher.

As of April 30, 2013, the Consumer Price Index (CPI) stood at a paltry 1.1%, under the Federal Reserve's target of 2% annually.¹ Why is this troubling? For a number of reasons:

• When companies don't have any leeway to raise prices, they're more apt to cut costs, which could mean a cutback in hiring.

• When inflation is low, it doesn't offer a large buffer against deflation if an economic shock occurs. Deflation -- when prices fall -- often freezes up spending. Why would you buy an item now if you expect it to be cheaper in a few months?

And it's not just the United States that is dealing with lower inflation -- or even deflation -- rates. Many of the world's top industrialized nations are in the same boat.

Inflation Rates Around the World (as of April 30, 2013)²

Stay Diversified

For investors, whether inflation continues to remain low or starts to rise, a well-rounded portfolio may be your best weapon. The key is to consider your time frame, your anticipated income needs, and how much volatility you are willing to accept, and then construct a portfolio with the mix of investments with which you are comfortable.

• CDs and Other Cash Instruments -- The Fed is still keeping a tight lid on interest rates, forcing investors who hope to keep pace with inflation by investing in cash instruments face a harsh reality. Average rates on a 1-year CD are hovering around 0.25%, while a 5-year CD is yielding an average of 0.78% nationwide, according to Bankrate.com. Money market accounts are averaging a microscopic 0.11%.³
• Bonds -- Historically, investors have turned to shorter-term corporate and high-yield bonds for protection in rising-rate environments.⁴ There are two types of bonds that receive a lot of investor interest when inflation starts to rise: Treasury Inflation-Protected Securities (TIPS) and I Savings Bonds. Both TIPS and I bonds are types of fixed-interest rate bonds whose value rises as inflation rates rise.
• Domestic Stocks -- Although past performance is no guarantee of future returns, historically, stocks have provided the best potential for long-term returns that exceed inflation.⁵ An analysis of holding periods between 1926 and December 31, 2012, found that the annualized return for a portfolio composed exclusively of stocks in the S&P 500^® index was 9.90% -- well above the average inflation rate of 2.98% for the same period. The results are almost as good over the short term as well. For the 10 years ended December 31, 2012, the S&P 500 returned an average of 7.10%, compared with an average inflation rate of 2.41%.⁶
• International Stocks⁷-- During the same 10-year span that ended December 31, 2012, the Morgan Stanley Capital International (MSCI) EAFE, which is composed of established economies such as Germany and Japan, outpaced the S&P 500 with an average return of 8.70%. The MSCI Emerging Markets index -- which tracks developing world economies such as Brazil and China, and is even more risky than MSCI EAFE -- was even more stellar, returning an average of 16.89%.⁸

Remember, diversification does not ensure a profit or protect against a loss. Consult your financial professional to discuss your specific needs and options.