According to Russell Investments, as of September 30, 2009, core inflation is currently at 1.40%, below the Federal Reserve’s unofficial target range of 1.50% – 2.00%. Hence, many have concluded that inflation is not present and perhaps not an imminent threat.  We, however, believe otherwise.  We, at Hennion & Walsh, believe that the threat of inflation may be upon us already and the impact of inflation could have a significant impact on the economy and on the portfolios of individual investors.

The Federal Reserve still needs to find an exit strategy for the roughly $1 trillion that it has already pumped into the system.  Getting money into the system seems to always be relatively easy. The difficulties arise in trying to get the money back out of the system. The timing of the exit strategy is critical and will likely be influenced by the timing of the return of economic growth. Additionally, if the Federal Reserve overestimates where U.S. economic growth should be in this new, and constantly changing, world economy, then they run the risk of keeping rates low for too long and over-stimulating the economy.

Hence, it may be appropriate to look for ways to help inflation-proof your portfolio. Having some allocation to traditional inflation hedges in your portfolio could not only help with return potential in the months ahead but also serve as a needed inflation buffer. Traditional inflation hedges generally include certain commodities or baskets of commodities, real estate, global infrastructure, diversified growth portfolio (often including some allocation to Equities) and Treasury Inflation Protected Securities (“TIPS”).  

TIPS seemingly provide the most direct exposure to inflation protection through the U.S. Treasury market yet are not understood by most investors. According to a PIMCO August 31, 2009 report entitled, “U.S. TIPS Market Characteristics,” all TIPS may provide:

• Inflation Protection – one component of TIPS returns comes from the direct link of TIPS principal to the monthly change in inflation, as measured by the CPI (consumer price index)

• Real Yield – the securities provide return potential that may exceed realized inflation, which is known as real yield.

• Low Default Risk – TIPS are backed by the full faith and credit of the U.S. government as to the timely payment of interest and principal.

• Diversification – TIPS may provide diversification relative to U.S. Treasuries and other investments that may underperform when inflation is high or rising.

In terms of investing in TIPS, investors may look to mutual funds but may want to consider the Exchange-traded Product (“ETP) marketplace as well. There are now different ETPs available covering different maturity ranges and regions that provide access to the TIPS product.  A sample listing is as follows:

Additionally, new issues of TIPS with maturities of 5 years, 10 years and 20 years can be purchased directly from the government through the TreasuryDirect program.  Aside from the purchases of new issues when they are auctioned, investors can also look to purchase TIPS in the secondary market through financial advisors at any point during the year.