The Time to Tame Inflation Is Well Before It Strikes

Right now, you might feel you don't need any insurance against a rise in the cost of living. Inflation, as measured by the Consumer Price Index, is running at negative-1.3% over the past 12 months; with oil and real estate down drastically, there are few signs of rising prices in daily life.

But the cost of living mightn't fall for much longer. So it is a good time to look at inflation insurance, in the form of U.S. Treasury Inflation-Protected Securities, or TIPS. The principal value of TIPS increases or decreases with the cost of living. Unlike normal bonds, TIPS don't get hammered when inflation rises.

There is a historic tug of war under way between inflation and deflation, with the federal government borrowing $1.9 trillion in the past 12 months even as prices of many goods and services continue to fall.

"Inflation uncertainty is probably wider today than at any time before the financial crisis," says John Hollyer, co-manager of the $22 billion Vanguard Inflation-Protected Securities fund. "So having that protection in your portfolio is still valuable."

Even when prices are going up, many people fall prey to what is called "money illusion" -- the tendency to overlook the corrosive effects of a rising cost of living. You would probably rather have a 2% raise in a time of 4% inflation than a 2% pay cut in a time of zero inflation. The pay raise feels more positive and will make you happier than the pay cut -- even though both alternatives are economically identical, leaving you 2% poorer after inflation.

So if people are prone to this fallacy, why are TIPS funds hot? Through May, inflation-protected bond funds accounted for $10.4 billion, or 11%, of all the new money that flowed into stock and bond funds this year.

I don’t think we have seen inflation because the money has not really hit the market place. It is lining pockets right now. That is why prices and wages are dropping. What happens when those with lined pockets decide to start spending, who knows.

3 posted on 06/30/2009 11:05:21 AM PDT by 50sDad (The Left cannot understand life is not in a test tube. Raise taxes, & jobs go away.)

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