Watch for Inflation When the Economy Rebounds

Ready or not, the era of big government is back and with it comes the potential revival of another dragon many investors thought was slain: inflation.

Clearly, inflation is not (repeat: not) a problem right now. Furthermore, the government's rapid response to the economic and psychological blows of Sept. 11 is one reason stocks were in recovery mode prior to Wednesday's steep losses. But investors who believe Sept. 21's low augured the start of another multi-year bull market need to consider the longer-term implications of the vigorous fiscal and monetary stimuli.

Citing a possible re-emergence of inflationary pressures and renewed complacency among investors, Thomas McManus, equity portfolio strategist at Banc of America Securities, reduced his rolling 12-month target for the S&P 500 to 1225 from 1275. He also lowered his recommended equity exposure to 65% from 70% earlier this week.

"The valuation of stocks leaves no room for inflation risk," McManus said. Stock valuations are partially a function of Treasury bond yields, which would very likely rise if inflation re-emerges.

Clearly, inflation concerns are not currently restraining Treasury bonds, which returned to rally mode this week amid fresh signs of economic weakness and rising anxiety about anthrax attacks.

Notably, McManus shifted that 5% of allocation from equities into bonds, which traditionally fare worse than stocks in an inflationary environment. However, one-third of his bond allocation -- now 30% of the total -- is earmarked for Treasury Inflation-Protected Securities (TIPS).

Historically, gold has offered investors protection against inflation. I'm often teased by colleagues for being TheStreet.com's resident gold bug, but gold-oriented funds were up 10.8% year to date through Oct. 12, according to Barron's; that kind of performance is no laughing matter in this most trying of years.

Even Edward Yardeni, chief economist at Deutsche Bank, who believes we are in a deflationary environment, recently noted that metals and mining stocks are "due for some relative gains." Other sectors that do well in periods of rising prices, namely paper products and chemicals, "are now starting to show signs of relative strength," he commented.

Still, much skepticism remains about where the inflation is going to come from, given the recent decline in energy prices and the economy's continued lethargy.

Regarding the former, it does not take much imagination to consider a scenario where oil prices suddenly begin moving higher, given the current geopolitical environment.

Regarding the latter, economic growth is not a prerequisite for inflation, as the "stagflation" of the 1970s demonstrated. A repeat of that unpleasant experience could emerge, but the government is going overboard to foster an economic rebound.

Priming the Pump

The Federal Reserve has lowered the fed funds rates to 2.5% from 6.5% at the beginning of the year, with 100 basis points coming since Sept. 11. In the immediate aftermath of the attacks, the Fed added temporary, short-term liquidity into the financial system at an unprecedented rate.

Still more monetary stimulus is expected: As of Wednesday afternoon, the fed funds futures market was pricing in near 100% certainty of at least a 25 basis-point rate cut at the Fed's next scheduled meeting on Nov. 6.

The so-called real fed funds rate is now negative compared with the annualized rate of the consumer price index and on par with the real personal consumption expenditures of GDP, which rose 2.5% in the second quarter.

In essence, the Fed is trying to promote spending by discouraging investors from holding dollars. But an effective devaluation of the dollar has inflationary implications because of its impact on import prices. Additionally, if foreigners decide to relieve themselves of dollar-denominated assets, it would have serious negative implications for stocks and bonds.

To date, the dollar has confounded expectations that it would drop sharply in the wake of the terrorist attacks. But dollar bears believe the greenback is being artificially -- and temporarily -- supported by a combination of short-sellers covering and the Bank of Japan's buying, as well as the European Central Bank's reluctance to cut rates.

While the Fed provided hefty monetary stimulus, the federal government approved $55 billion in emergency relief and subsidies for the airline industry after Sept. 11. The House of Representatives passed a $100 billion spending bill, although final legislation probably will be closer to the Bush administration's proposed $60 billion to $75 billion.

In addition to increased spending, the Bush administration also is committed to lower taxes above and beyond the $1.35 trillion tax cut approved earlier this year. The House's spending bill contained many elements supported by the White House, including a repeal of the corporate alternative minimum tax, an immediate reduction of the 28% income-tax bracket to 25%, a reduction of rates on adjusted net capital gains, and incentives for business to write off assets.

When military spending and additional tax relief are included, actual fiscal stimulus may approach $130 billion, estimates Mickey Levy, chief economist at Banc of America Securities, who noted 1% will be added to GDP for each $100 billion in government spending.

"Aggressively stimulative monetary and fiscal policies point toward rebound beginning in early 2002," according to Levy. "The result will be a V-shaped pattern in economic performance."

Classic indicators suggest that the rebound will be vigorous, Levy said, citing rapidly expanding money supply growth -- with M2M over 19% on an annualized basis, and the fact the reduction in business inventories was well underway prior to Sept. 11. Additionally, the Treasury bond yield curve is at its steepest level since 1993, according to Bloomberg.

But Anthony Crescenzi, chief bond market strategist at Miller Tabak, is not sure "traditional analysis" works in the wake of Sept. 11. He remains bullish on the long end of the Treasury yield curve.

The Coming Rebound

"Fed rate cuts and fiscal stimulus won't put people back in airplanes -- when people disengage, stimulus is less helpful," Crescenzi said, noting consumer spending in Japan has remained moribund despite interest rates that were effectively 0%.

Crescenzi didn't expressly say it, but other observers believe the Japanese experience suggests Fed rate cuts will be ineffective in reviving consumer spending.

I disagree and (for once) agree with Alan Greenspan, who testified Wednesday that the pullback by households and businesses in the wake of Sept. 11 "has been partial and presumably temporary."

As Greenspan observed, 0% financing by major automakers "induced a sharp rebound in motor vehicle sales." Also, low mortgage rates are keeping the housing market afloat -- U.S. housing starts rose 1.7% in September, defying expectations for a decline.

Furthermore, I don't believe Americans will let terrorists ruin the holidays and will shop with vigor. Given our newborn daughter's already burgeoning wardrobe, I can attest that people still relish giving for happy occasions, perhaps more so now than ever.

Again, all this portends better-than-feared economic times ahead in the short-to-intermediate term, but possibly nettlesome problems for investors in the long run.

Levy, who agrees the inflation risk is long-term, nevertheless believes "the Fed is going to have to tighten to head off those inflation risks," a possibility true long-term investors need to be aware of.