TCS Daily

Hating Inflating

By James K. Glassman - June 18, 2004 12:00 AM

One of the most enduring achievements of the late Ronald Reagan "stands all but overlooked," my colleague Robert J. Samuelson wrote in The Post last week. Reagan whipped inflation.

It's easy for us to forget, but in 1979, on the eve of Reagan's election, inflation was terrifying and debilitating, with "the kind of dominance that no other issue has had since World War II," according to opinion expert Daniel Yankelovitch.

In 1976, the consumer price index, our standard measure of inflation, rose 4.9 percent; in 1979, it rose an incredible 13.3 percent, with no end in sight. As the 1980 vote approached, the public rated the problem of "holding down inflation" three times as important as "finding jobs" -- even though the unemployment rate was a hefty 7.1 percent.

It was Paul Volcker, the talented and courageous Federal Reserve chairman, who raised interest rates and brought inflation below 4 percent by 1982, triggering a recession in the process. But it was Reagan who supported and encouraged Volcker and gave him what David Stockman, then the budget director, called "the political latitude to do what had to be done."

With the exception of 1990, when it spiked to 6 percent, inflation has remained relatively tame for the past 22 years, but there are now signs that it is rising again. Over the past three months, the change in the CPI, on an annualized basis, has been 3.9 percent. While much of that increase stems from the sharp increase in the price of a single commodity, oil, it's still a troubling development.

What's wrong with inflation? It demoralizes consumers, destroys the buying power of people on fixed incomes and makes rational planning extremely difficult for businesses.

Inflation causes interest rates to rise. Say you lend someone $1,000 for 10 years (the same procedure as investing in bonds). Because of inflation, the $1,000 you get back at maturity can't purchase as much as the $1,000 you originally lent, so you demand higher rates of interest to compensate for the loss; the higher the expected inflation, the more interest you'll demand.

Also, as Volcker demonstrated, inflation inevitably leads to action by the Fed -- hikes in short-term rates to bring rising prices to heel. Nearly everyone expects the Fed to start raising rates again, either at its meeting June 29 or the one on Aug. 10.

High interest rates deter consumers from buying houses, cars and other big-ticket items because they can't handle the debt load. Higher rates also raise corporate borrowing costs and cut into profits. And, finally, higher rates make lending more attractive, enticing investors to sell stocks and switch into bonds, causing stock prices to stagnate or fall.

In the June 4 issue of his influential newsletter, Grant's Interest Rate Observer, James Grant, an expert on the history of debt, argued that we're heading into a new secular, or long-term, period of rising interest rates. The cycles are clear: Interest rates fell in the last 40 years of the 19th century, rose in the first 20 years of the 20th century, fell between 1920 and 1946, rose between 1946 and 1981, and fell between 1981 and 2003.

"Now, we believe, they are going back up again," Grant writes. "If the past is prologue, they might go up for a very long time."

Perhaps. But let's not go overboard. Last year's CPI, bolstered by rising gasoline and food prices, rose 2.3 percent, but many economists think that the pace this year will fall a bit. The respected Web site expects the CPI to rise 1.9 percent. Even 2.5 percent would compare favorably with average inflation rates of 3 percent since the mid-1920s and 5 percent between 1970 and 2000.

Also, remember that the last time investors were concerned about inflation, the Fed aggressively raised rates seven times, going from 3 percent in early 1994 to 6 percent in early 1995, yet those increases did not begin a new epoch. To the contrary. Eight years later, the short-term rate was down to 1 percent, where it remains today.

Still, it's a good bet that interest rates will go up, and the key question is which investments will benefit -- or won't be hurt so much.

Before we get to the answers, two points:

First, for long-term investors, buying specific stocks simply because they will get some benefit from higher rates doesn't make a lot of sense -- unless you're convinced that Grant is right and we're entering a new cycle.

Second, don't panic. This is not 1979. Inflation is low, and there is good reason to believe that macroeconomic forces will keep it low. Prices are determined by supply and demand, and the most striking change in the world economy in recent years has been the powerful increase in supply, as China became a bigger producer, as transportation of goods across the globe became easier and as the United States itself became more productive. Rising supply keeps a lid on prices.

"It is unlikely that inflation will exceed 2.5 percent, in my opinion," wrote Byron Wien of Morgan Stanley in an excellent letter to clients on June 1, "and a 10-year U.S. Treasury yield in the area of 5.5 percent [it was 4.8 percent on Thursday], accommodating a 3 percent real rate, should not impede further stock market progress."

Wien said that for the bond market "to become a serious problem for stocks," the rate on 10-year Treasury bonds has to rise to 6 percent or higher and stay there. He said that's "unlikely this year." Meanwhile, short-term rates should stay low. Wien doesn't think we'll see more than a 1 percentage point increase by year's end.

Not only does Wien believe that inflation and interest rate increases will be moderate, he's also sanguine on rising rates in general. An analysis of the five Fed rate increases since 1983 found that "the market has generally risen in the year after the first hike." Even in 1994, when the Fed sharply increased rates, stocks were down three months after the first hike but had posted gains after 12 months. Nine months after the 1986 rate increase, the S&P was up more than 30 percent.


Except during extreme periods like the mid-1970s and the early 1980s, interest rates generally rise because the economy is booming; demand is rising, and it bumps up against supply, increasing prices. While inflation and higher interest rates are negatives, the positive effects of consumer and business activity counteract them.

The best-performing sectors 12 months after the five rate increases studied by Wien and his colleague Michelle Weinstein were: technology hardware, up 25 percent; pharmaceuticals and biotechnology, up 22 percent; health care equipment and services, up 20 percent; food and drug retailing, up 17 percent; media, up 17 percent; and software and services, up 14 percent.

Health care and grocery retailing tend not to be affected by rising rates because people can't defer such purchases and don't go into debt to make them. As for technology, the reasons for its success are murky, but small-caps have nearly always beaten large-caps during periods of inflation and rising rates.

To return to inflation alone: Aren't stocks hurt by it? Yes, but not nearly as much as bonds. Stocks represent the value of a business, and during periods of inflation a business can usually raise its prices to keep up with higher costs. Bonds, on the other hand, pay a rate of interest that doesn't change. Borrowers cheer for inflation; lenders (that is, bond investors) dread it.

During the worst five-year period for inflation in history (1977-81, when the CPI rose an average of 10 percent annually), large-company stocks registered average returns of 8 percent a year; long-term government bonds (including both interest income and price declines) fell 1 percent. This was no fluke. In the period of high inflation during and after World War II, large-cap stocks returned 13 percent; Treasurys, 3 percent. (Small-caps, by the way, returned 25 percent.) It's true that in high-inflation periods, stocks do not keep pace with consumer prices, but again, make a comparison with bonds. Between 1973 and 1981, the worst inflationary period of the 20th century, long-term government bonds produced negative returns, after inflation in eight of nine years, and the purchasing power of a $1,000 investment fell to $564, compared with $712 for stocks.

I'm not saying that bonds can't provide a haven. You can buy TIPS (Treasury Inflation Protection Securities), government bonds whose value floats with the CPI, either individually or through a mutual fund like BBH Inflation-Index Securities (BBHIX), which carries a five-star (tops) rating from Morningstar and charges annual expenses of 0.7 percent.

Vanguard Inflation Protection Securities fund (VIPSX) hasn't been around as long as the BBH fund, but its returns have been the same over the past three years, and its expense ratio, at just 0.2 percent, is lower.

A riskier approach is offered by Fidelity Floating Rate High Income fund (FFRHX). Launched in September 2002, it owns a portfolio of commercial loans whose payments rise as interest rates rise. But beware: If rates rise too much, some corporate borrowers could get strapped for cash and default on their payments. With more than $2 billion in assets, the fund, which charges modest expenses of 0.9 percent annually, has proved to be popular, but it returned just 6.5 percent last year and is only barely making a profit so far in 2004.

Rates on conventional Treasury, corporate and municipal bonds have all risen in recent months, and some investors will find them attractive right now. But if rates keep going up, a decision to buy bonds now could seem awfully foolish. Still, munis especially deserve attention as state and local agencies need to raise money to meet budget shortfalls and, thus, have to raise interest rates to entice buyers. Interest on munis is tax-free, so an investor in a 35 percent tax bracket would need a yield of 6.9 percent on a taxable bond to match the return on a 4.5 percent muni.

Finally, if you're truly spooked by higher inflation and interest rates, you can invest in precious metals and other commodities, whose prices tend to rise with inflation (or in anticipation of it), or in money-market funds, which are simply very short-term bonds. Money markets pay practically nothing today, but if rates rise, their returns will rise as well. You're not locked into today's yields, as you are with medium- or long-term bonds.

If inflation reverts to the average rate during the last 30 years of the 20th century, it will erode the value of your investments dramatically. At that pace (5 percent annually), the purchasing power of a dollar will diminish to 3 cents during a human lifetime. Or look at it another way: In 2000, you had to make a salary of $100,000 in order to match the purchasing power of a salary of $23,000 in 1970.

So take inflation, and the rise in interest rates that accompanies it, as seriously as Paul Volcker and the late Ronald Reagan did.


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