Viewpoint: Tracking Fed's impact on inflation

November 20, 2009

Government's fiscal policy can positively and negatively impact economy.

Key Points

The economy also is influenced positively and negatively, at times, by the government's fiscal and monetary policy. Fiscal policy, implemented by our elected leaders, is the use of government spending and taxation to influence the economy. Many individuals with whom I speak have expressed concern about the current budget deficits, rising national debt, and the possibility of higher taxes.

Monetary policy is run by the Federal Reserve, an independent body not directly accountable to the voters. Recent acts by the "Fed" include lowering the short-term lending rate (Fed funds rate) to 0 percent. More relevant to you is the prime rate, which typically is about 3 percent above the Fed funds rate. This is the rate that is mainly used on your lines of credit and credit cards as well as on short-term lending rates that builders and other businesses use for borrowing. The Fed also has devoted an enormous amount of money to holding down long-term interest rates and mortgage rates by buying mortgage-backed securities and longer-term U.S. treasuries.

The Fed's position is that it needs to save the economy first and deal with the consequences later. The difficulty is that any policy moves made by the Fed always take six to 12 months to filter into the economy. Given this lag, the Fed is trying to estimate what inflation is going to be in the future, not necessarily what it is today. This approach is the reason that many economists will adjust current measures of inflation such as the Consumer Price Index and Producer Price Index to try to analyze what factors temporarily are affecting inflation versus factors they expect to persist.

So, what are some things you can do to diversify and "hedge" your risk against inflation? Several areas to consider for a portion of your fixed-income portfolio are U.S. Treasury Inflation Protected Securities (TIPS). Pimco and Vanguard have funds dedicated to TIPS as well as exchange-traded funds from Ishares. Real assets, such as commodities including crude oil, energy, timber, and gold, historically have been a good hedge against inflation. Commodities, however, can be extremely volatile, so make sure you understand what you are buying before investing.

Given historically low interest rates, there may be no better time than today to get your financial house in order. Consider taking advantage of current rates and locking in low long-term rates on your home or office building. Focus on getting yourself into a low-debt, strong liquid position, which will be important in a world with tighter credit and requirements for higher down payments.

Although it seems likely that inflation will increase, no one knows what the future holds. That uncertainty is the reason that investing involves risk and that proper diversification is important, even if we may overweight certain asset classes or strategies that we believe are more probable to occur in the future.

The author is a fee-only certified financial planner with Preston & Cleveland Wealth Management LLC (http://www.preston-cleveland.com) in Atlanta and Augusta, Georgia, and a member of the National Association of Personal Financial Advisors. The ideas expressed in this column are his alone and do not represent the views of Medical Economics. If you have a comment or a topic you'd like to see covered here, please e-mail meinvestment@advanstar.com
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