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Inflation? Deflation? Hedge Your Bets

Whichever scenario proves correct, inflation-protected bonds known as TIPS provide a safe haven.

Investors who are trying to sort through the economic news and figure out which way to go can't be blamed for feeling like Dorothy when she asked the Scarecrow how to get to Oz, and he pointed one arm in each direction. One group of economists tells us our biggest worry is inflation, and the other group says we're in for a period of deflation.

The two scenarios dictate entirely different investment strategies. Commodities and real estate do well in periods of inflation; bonds are a natural for deflationary times. It's a mistake to pick one road. What we need to do is understand the situation and then hedge our bets. One investment shows some promise in helping us to do that: Treasury inflation-protected bonds, or TIPS. But first, let's look at the evidence.

Inflation means rising prices. But it hasn't been a threat for so long that many investors don't remember how it wrecked the economy and markets in the 1970s. Stocks were a disaster; so were bonds, where investors saw losses of 30% to 40%. Mortgage rates hit the mid- to high teens. I got a 14% mortgage on my first house and considered myself lucky. Some economists said inflation was an intractable problem. Then Paul Volcker was named


chairman, and he broke the back of inflation by raising interest rates and limiting the flow of money into the economy.

Is Inflation Whipped Now?

This scenario could repeat, but it's unlikely. Fed policymakers have learned a lot of lessons since 1980, and those lessons have held inflation down to a rate of 1% to 3%. But those who argue the inflation scenario point out that home prices have held steady during the current recession, that price cuts are concentrated in energy and hard goods such as autos, and that if you take out food and energy, the consumer price index is actually increasing at nearly 5%. The inflation team also argues that the costs of services, especially for medical care and college, are escalating rapidly. I saw that when I got my health insurance premium increase notice this week; it is up more than 30% from when I got the policy four years ago.

But the other group of economists argues that the real concern is deflation, or decreasing prices. That may sound good, but deflation is very damaging, as Japan has learned recently. Wages go down and unemployment goes up, as it did in the Great Depression. If you have a mortgage or credit card debt, every dollar you pay back is worth more than the dollar you borrowed. Inflation is troublesome; deflation causes revolution.

The Deflation Scenario

The evidence offered for the deflation scenario is that the producer price index is falling, the price of gasoline is back to its 1985 level, computer prices have fallen 31% from a year ago, airfares and hotel rates are dropping, stock prices fell in 2000 and 2001, and so did the individual net worth of American households. Debt hit a new high of more than 21% of disposable personal income.

I find it interesting that you can pick out the statistics that bolster your argument. Gasoline prices, on an inflation-adjusted basis, are lower than they were in the 1973 oil crisis. And computer prices have been coming down for as long as I can remember. In 1984, when I started working for myself, I invested $4,000 in an IBM PC with no hard drive, just two floppy-disk drives. Last week my husband bought a computer that could probably run the U.S. space program for $700 plus add-ons. My point is that there are other factors at work in the price of computers and energy. As for U.S. travel, we all have a pretty good idea of what caused the falloff there.

How to Deal With Debt

Both inflation and deflation are bad for stocks. But some forecasters say the economy is already rebounding and that this is the time to buy stocks. What's the best response to these conflicting signals?

Some common-sense solutions apply to any economic situation. It makes sense to pay down debt to increase your flexibility. It also is a mistake to get hysterical and do too much trading. But as I mentioned, the bonds nicknamed TIPS merit a look.

The U.S. government guarantees that these bonds, introduced in 1997, will provide a return pegged to the rate of inflation. And because bonds are a great investment in deflationary periods, TIPS look like a good hedge for the inflation/deflation conundrum. Indeed, studies such as Ibbottson's November 1999 "TIPS as an Asset Class" have shown that TIPS act like a separate asset class.

Tips on TIPS

TIPS carry a fixed interest rate, but the principal value is adjusted for inflation. Say you invest $1,000 in a 10-year TIP with a 3% coupon, or interest rate. If inflation is 3% over the next six months, the principal of your bond is adjusted to $1,030 ($1,000 plus 3%) at the end of that period, and your interest is $15.45, or $1,030 times 3%, divided by two.

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If inflation held at 3% over the 10-year life of your bond, you would get $351.56 in interest, and your principal would grow to $1,344 at maturity. In a period of deflation, your principal would be adjusted downward for purposes of figuring interest payments. But the government guarantees return of principal at maturity.

There is a downside: The increase in principal is taxable as income in the year it accrues, even though you don't actually receive it until maturity. This is referred to as "phantom income." It may be a phantom, but it shows up on your tax bill. So in the example above, the $30 increase in principal would be taxable in the first year. That makes TIPs less attractive for taxable accounts.

For tax-deferred accounts, though, they're worth examining. There are a number of mutual funds that offer TIPS, including

(VIPSX) - Get Vanguard Inflatn Protect Secur Inv Report

Vanguard Inflation-Protected Securities;

(PRRIX) - Get PIMCO Real Return Inst Report

PIMCO Real Return Bond Institutional ;


American Century Inflation Adjusted Treasury;


GMO Inflation Indexed Bond and


59 Wall Street Inflation-Indexed Securities.

At the time of publication, Mary Rowland owned or controlled shares in none of the equities mentioned in this column.