CHICAGO -- The Morningstar Investment Conference got under way Thursday, and the initial talk among the panelists was about warmongering. But while Iraq and terrorism were mentioned, the real war the fund managers and economists are supporting is the one against deflation.

Taking the lead charge, of course, is the Federal Reserve.

"They won't say so in plain English, but the Fed wants a higher inflation rate," said Paul McCulley, managing director and portfolio manager at the bond powerhouse Pimco. "The Fed will not tighten monetary supply until we can observe a visible reinflation environment."

But while the panelists agree that President Bush and the Federal Reserve will succeed in their pull-out-all-stops push to pump up the economy -- indeed, they counseled investors to plan for an environment with higher inflation -- some expressed concern about the economy's long-term health.

Fighting a New War

The need for reinflation -- an assessment with which all panelists agreed -- comes from a mix of political and economic cycles.

The 1960s and 1970s saw a bull market in government, with capitalism in retreat, McCulley said. Monetary policy was conducted with an eye toward the Oval Office, and the goals were to limit private investments with government deficits, and to have higher regulation of the private sector. The 1980s and 1990s, though, saw the reverse. Monetary policy kept its eye on the bond market, private investment with government surpluses was encouraged, and deregulation reigned. But the bull market in capitalism ended with the new millennium, and now we're in a period during which capitalism is in retreat and deflation risk dominates.

The cure: a monetary policy of reinflation.

Monetary policy has shifted from a hard-money orientation with an eye toward the wishes of the Oval Office in the 1960s and 1970s to a 20-year war -- "a war, not a battle," McCulley said -- against inflation. "The Fed has finally got it," McCulley said. "They declared victory belatedly, but now have embarked on a new war."

The near-term result of this push for reinflation is a bubble in the Treasury bond market. "That's a paradox we're grappling with," McCulley says. "In order to see a reinflation of the economy, it's necessary that the bond market believe that the Fed can't accomplish that. But if the bond market believes the Fed will fail, a bubble in Treasuries will result, long-term rates will come down, and the Fed will be successful."

Playing Politics

The panelists expect the Fed to succeed -- largely because it has to, but also because it will have the full support of the federal government.

"President Bush has a limited agenda," said Byron Wein, managing director and investment strategist for Morgan Stanley. "Avenge his father's incompleteness in Iraq and -- embarrassed by his marginal victory in 2000 -- win big in 2004. That means he's willing to pull out every federal stop to do so, and Federal Reserve Chief Alan Greenspan will help him."

But the panelists were far from sanguine. "My biggest worry is that we're the leading economy in the world, and we don't make anything," Wein said. "The trade deficit is probably the biggest problem facing us, and it's a serious one -- not just for the U.S. but also for the world."

Manufacturing, still in its long slump, is the backbone of economic health, Wein said. It's how this nation became the economic powerhouse it is; it's how Germany and Japan emerged from the ashes of World War II. And Japan's trade surplus -- funded by its manufacturing culture -- is what has sustained it thus far. "If Japan had a trade deficit, the country would be out of business by now," Wein said.

The panelists advised investors to plan for an environment of higher inflation. That means shortening the duration of most bond portfolios. Daniel Fuss, a portfolio manager at Loomis Sayles, said his firm's average duration has gone from 9.8 years a year ago to 6.8 years now. "The timing here is a risk, though," he warned. "Getting too short too soon can force you to extend out farther on the yield curve at the wrong time."

Other inflation hedges suggested for bond portfolios are TIPS, or Treasury inflation-protected securities, which guarantee that your principal investment won't be eroded by inflation, and corporate bonds, which McCulley referred to as "a call option on deflation."

And as a hedge against the Fed's failure to increase inflation -- which would create a downdraft of deflation, a declining dollar and higher unemployment -- McCulley suggested high-quality, long-term European bonds. "The European Central Bank has a whole lot more room to pull down interest rates than the Fed does," he said.

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