Guest Column: Federal Reserve aims to break deflation cycles

As the global economy continues to contract in response to the credit crisis of the past seven months, concerns of deflation have arisen, and these concerns have been the focus of recent Federal Reserve actions.

Deflation - the contraction in the volume of available money or credit that results in a general decline in price - began in a significant way in the housing market in 2007 and has subsequently spread to most commodity prices in the last nine months.

A sustained period of deflation can significantly harm an economy because when consumers, businesses and investors anticipate that the prices of goods, services and assets will be lower in the future, purchases will be deferred. This can create a self-fulfilling downward spiral in prices.

Furthermore, when asset prices decline, any associated debt burden increases on a relative basis (i.e. owner equity declines or is eliminated), which is the root of the problem now being seen in the housing market. Breaking this vicious cycle has been the focus of the Fed as it rapidly expands the monetary base.

Money supply

The aggressive expansion of the money supply has been a concern to many economists who fear that the end result will be a period of above-average inflation. There are generally two potential sources of inflation pressure in our economy: one that is associated with the output gap, and the other as a consequence of monetary policy.

Today, inflation derived from expansion of our monetary base is a more relevant concern for three primary reasons.

First, as the U.S. "prints money" to fund the various and large measures being taken to stabilize the economy, there is potential for the dollar to depreciate.

If this were to happen, all things valued in dollar terms - commodities, imports, et cetera - will rise in price, all other things being equal.

Second, the amount of new U.S. Treasury borrowing is set to increase significantly in the next 12 months and could result ina crowding out of private-sector borrowing.

Many economists believe that Treasury note yields will have to rise significantly in order to attract investor interest. This would, in turn, force a rise in the borrowing costs for individual and business borrowers, which also is inflationary.

Finally, to the extent that these stimulus measures begin to take hold and the economy improves, the large injections of liquidity could translate into too much money chasing too few goods - also causing inflation.

In the past six months, although the money supply has increased, the velocity of money has declined significantly. What this means is that consumers have chosen to save - the consumer savings rate is now at 4.5 percent versus slightly negative a year ago - rather than spend discretionary income into the economy. This reduces the economic and inflationary impact of monetary expansion.

But just as the expansion of the monetary base has been necessary to mitigate further economic deterioration in the near term, effectively pulling the excess liquidity out of the economy once conditions improve will be equally important. Given the significant lag between Fed action and the impact on the economy, this can be as much art as science.

Certain strategies can be utilized to provide an improved buffer for an investment portfolio should inflation accelerate:

• an incremental shift to international stocks, which protects against dollar weakness;

• a consistent allocation to commodities, likely to be the first area to re-inflate;

• and an additional emphasis on emerging markets, many of which are natural-resource rich nations and best positioned for currency strength.

The bond components of portfoliosmay be the most sensitive to higher inflation and interest rates; however, there also are opportunities to hedge inflation risk here:

• Avoid the purchase of Treasury bills and notes at sub-3 percent yield levels.

• Maintain an intermediate or shorter duration.

• Take advantage of opportunities in the investment-grade corporate and mortgage bond areas, where above-average yields over Treasuries are available.

• Gradually add inflation-protected bonds in portfolios as prices stabilize and eventually rise.

The primary goal of our central bank is to promote sustainable economic growth with relative price stability. Modest levels of inflation are expected and desired when this goal is met.

The past six months, and the several years ahead, will be a real test of the effectiveness of the Fed's efforts.Jeff Layman is chief investment officer of BKD Wealth Advisors in Springfield and a Chartered Financial Analyst.