Inflation, a serious concern a few months ago, has all but disappeared from inves-tors’ radar screens. But it isn’t dead. Even in the current economic environment, prices of some goods and services are considerably higher than they were a year ago. And once the global credit crisis ends and healthy economic growth returns, inflationary pressures will re-emerge.

Indeed, unless central banks figure out the right time and pace at which to raise interest rates, sharply higher inflation will be a risk. The banks will need to remove from the financial system the liquidity they are currently pouring into it. If they don’t move soon enough and fast enough, too much money could be chasing too few goods — a classic recipe for rising inflation.

But this situation is probably two years away. The question is whether you should be discussing the longer-term threat of inflation with your clients now. Some experts say no; others say yes.

“It’s the last thing you should be concerned with,” says David Runkle, director of quantitative research with New York-based Trilogy Global Advisors.

Runkle points out that any profound global economic slowdown leads to excess capacity world-wide. The first place that’s typically felt is in the materials sector. “The fact that oil has crashed and burned,” he says, “is an indication of exactly how much tailwind there is in commodities.”

Clancy Ethans, Richardson Partners Financial Ltd. ’s chief investment officer in Winnipeg, and Andy MacLean, Richardson’s director of private investing in Toronto, agree. Even in the medium term, they say, inflation may be a “non-event.” How long inflation sleeps depends on how serious the global slowdown is and how big the output gap — the amount economies are producing compared with what they could produce — is when healthy growth resumes.

For example, if the price of oil falls to US$40 a barrel, that would indicate much more excess supply than if it is US$70 a barrel. The same principle applies to other commodities, as well as to unit labour costs. Labour costs are a big issue in the industrialized world, where much of what we consume are services and highly processed goods, which typically have a high labour component.

Paul Vaillancourt, senior vice president and director of portfolio strategy with Franklin Templeton Investments Corp. in Calgary, also views inflation as “on the shelf” for the moment: “But the longer-term theme is still emerging markets and the growth of the middle class in the developing world. We have to go through a de-leveraging period in the next couple of years. But then there will be reflation.”

Andy Beer, manager of strategic planning with Winnipeg-based Investors Group Inc., is less sanguine. In the short term, inflation could continue to be an issue, he says. The year-over-year increase in the consumer price index was 3.5% in August, up substantially from 2.4% in January. Rising food and energy costs are driving the higher CPI; excluding those items, inflation was just 1.2% in August. But food and energy are things we buy every day.

Still, a few years of low inflation should not change long-term inflation assumptions. Over 20, 30 or 40 years, this period of low inflation will be insignificant and, indeed, offset by years in which inflation is relatively high.

EATING AWAY AT VALUE

The biggest issue for your clients, however, is the way in which inflation eats into the real value of assets, says Beer. This raises two questions: what inflation rate should you assume when projecting clients’ income needs; and how do you ensure that your clients’ portfolios generate sufficient returns so that they don’t lose future purchasing power?

Even if you agree that inflation is not a problem in the short term, clients need to assume that prices will go up in the long run. That means financial plans should continue to assume an inflation rate of 2%-3%. Some advisors are going even further and assuming 4%.

That may seem high, given that the Bank of Canada’s inflation target is 1%-3%. But it’s much better to have inflation come in lower than expected, giving clients extra purchasing power. If it comes in higher, clients will scramble to reduce less crucial expenditures so they can afford necessities, or they will watch their capital and purchasing power erode.

@page_break@There are also advisors who see an increase of as much as 10% for education and medical expenses, and are factoring those higher costs into clients’ financial plans.

Inflation assumptions are a particularly critical issue for very conservative investors, who gravitate toward guaranteed income certificates, whose returns don’t necessarily cover rising prices. The solution, says Beer, is adding other asset classes that are likely to appreciate — at least, enough to cover inflation.

Equities, of course, are an obvious choice, but you may have trouble persuading clients to buy, particularly in the current market. Beer suggests you start by persuading clients to include real estate investments. Although these may also be a hard sell for clients concerned about a cooling housing market, they’re probably an easier sell than equities. Housing prices can go way up and way down, but people have seen with their own homes that, over the longer term, there’s a general upward trend.

That makes real estate — including rental products, as rents usually increase annually — a good hedge against inflation. In addition, clients don’t have to own properties directly. They can buy mutual funds that invest in real estate.

Real return bonds, whose interest covers the rise in the CPI, should also be an easy sell.

Here’s a brief backgrounder on inflation.

> Causes. Inflation is usually caused by too much demand and too little supply. There isn’t enough of a particular good or service to go around at the current price, so the price has to rise to dampen demand. That’s not, in itself, a problem. The danger is that producers of other goods and services are forced to raise prices because their costs have gone up as a result, thereby broadening the sources of inflationary pressures.

But even that isn’t a major problem, unless workers demand big wage increases to cover the higher prices they are paying. If companies give in to this demand, an upward spiral of inflationary pressures can develop, as higher wages lead to further increases in the cost of goods and services, prompting another demand for further wage increases — and a cycle is created. Note that once wages go up, it’s almost impossible to reduce them; it usually takes a serious recession to flush the system of inflationary pressures.

The higher the wage component in production, the greater the inflationary risk. That makes industrialized countries particularly vulnerable, because they consume many more services for which labour is usually the major cost.

In recent years, it’s been emerging countries’ demand for commodities as they industrialize that has produced most of the inflationary pressures. Industrialization requires energy and metals, while higher wages in those countries gives consumers the power to buy better-quality foods. The result: a commodity price boom.

What didn’t happen was a big increase in wages in the industrialized world to compensate for the squeeze on household budgets — thanks to competition from the emerging world. Low labour costs in the latter countries create a powerful competitive advantage. Industrialized workers in emerging markets know that their employers can’t raise the prices of the goods they produce without losing market share. In many cases, fear of job losses have inhibited demands for higher wages.

> Measuring Inflation. Inflation is measured by pricing a specified basket of goods and services, which are selected to represent the average mix of spending by consumers. Increases in the total cost of the basket are tracked and compared with its cost a year earlier.

The problem with this is that no one purchases that exact basket. No one, for example, both rents and owns a residence. And cars, appliances and furniture are purchased only periodically. Some people drive cars to work, while others take public transit. Grocery bills can differ widely. So, everyone’s inflation rate is different.

PERSONAL INFLATION RATE

Because clients can’t calculate their own inflation rate, they have to go with their sense of average inflation, then make adjustments according to their buying habits and whether they believe those prices will go up more or less than the prices of items in the average basket. People with large education and/or medical expenses may want to apply a higher inflation rate to those items in their financial plans.

> Controlling Inflation. Central banks worry about “core” inflation, which excludes food and energy. The prices of these necessities are very volatile, and spikes in food and energy prices are not important unless they influence wages.

When central banks believe there is upward pressure on core inflation, they control it by increasing interest rates to slow economic growth. Rate hikes reduce borrowing, thereby reducing liquidity in the economy. The resulting slowdown in economic activity lowers demand sufficiently to dampen the inflationary pressures, including the pressure for higher wages.

The opposite is happening at the moment, with central banks lowering interest rates and injecting liquidity into the financial system in order to jump-start bank lending. The goal is to encourage businesses and consumers to borrow to help fund the expansion of economic activity.

But, at some point, inflationary pressures will re-emerge and there will be a need to raise interest rates. Choosing the right time and pace at which to raise interest rates isn’t easy. If central banks miscalculate, either inflation continues to rise or a recession, rather than a slowdown, occurs.

> Future Inflationary Pressures. There’s no doubt there will be inflationary pressures once global growth resumes. But no one knows how great these will be. There will certainly be continued industrialization in emerging countries. But what about the supply side?

There is no unanimity on future oil supplies, for example. Some analysts believe conventional oil production has peaked, requiring expensive production of harder-to-recover reserves, such as the tarsands and offshore deposits. That will take oil prices higher. Others think supply is still good, or believe that technological advances will reduce the costs of the tarsands and offshore oil production.

Metals prices are more cyclical because demand for infrastructure, machinery, equipment, cars and appliances moves with the overall economic activity. New supplies, as deposits are discovered and mined, are also a factor. Nevertheless, the general price trend is likely to be upward, both because of continuing demand from emerging countries and because new deposits are likely to be more expensive to mine than current production.

Food prices will also trend upward, but there will also be a lot of volatility as weather conditions produce huge crops in some years and poor ones in others.

Emerging-market consumers — there are two billion of them in China and India alone — will improve their diets as they improve income, buying higher-quality foodstuffs. They are also likely to consume more meat and prepared foods.

The move to biofuels based on agricultural products could also push up prices for those
commodities. IE