Inflation Rate Risks

Has QE3 set the stage for dangerously high inflation? The third round of quantitative easing (QE3) that was announced in September of 2012 launched a $40B a month, open-ended bond purchasing program in the United States. QE3 is different from the first two rounds as it is basically unlimited in scope and direction.

The US Fed will continue to print money to buy these mortgage backed bonds indefinitely until it sees a “significant improvement in the labour market”. While the job numbers have been slowly improving, a “significant improvement” could take many years. In the meantime, this constant and heavy influx of cash runs the risk of pushing inflation levels well beyond comfortable levels.

At the start of 2012, the US Fed announced their goal to keep inflation at a steady 2%. This would allow the economic recovery to progress at a measured pace. Following the announcement of QE3 (which made no mention of this goal from 9 months earlier), the inflation expectations immediately jumped up to around 2.5%. So will the Fed allow this overshooting to take place? Most likely yes, at least for awhile. When left to decide between keeping inflation low and getting people back to work, the need to strengthen the labour market will ultimately win. As we start to see more signs of life in the job market, the Fed won’t be in a rush to start removing liquidity too quickly until they’re sure that the recovery is sustainable enough.

So what does this mean for you? Should you be worried about rising inflation rates? There has been an alarming increase in the transfer of investment funds from the equity markets to bonds and term deposits. While almost all portfolios need some level of these fixed income investments, too much can have serious consequences.

For example: A retired widow decides that she no longer feels comfortable with the stock markets and moves her entire non-registered retirement portfolio into GICs. Now let’s say she has $200,000 in this portfolio and no other retirement assets or pensions to her name. If she is earning 2% per year on her GIC’s and then pays 25% in taxes on those earnings, she’s left with an after tax return of 1.5%. Now if inflation moves up slightly to 2.5%, she’s actually losing 1% per year when you look at her inflation adjusted return. That means that she is rapidly depleting her retirement income as she draws money out to live on while simultaneously having her buying power of what’s left shrinking.

As I stated above, I’m not trying to say that investors should hold any fixed income investments, just that they need to beware of the risks in going all in to this asset class. Balancing out your fixed income portfolio with high quality, dividend producing equities will help to cushion the blow as interest rates and inflation slowly start to move upwards. Protecting your buying power and ensuring you don’t outlive your retirement funds is just as important as providing security and capital protection.

I want to be clear that I don’t think we’re going to see a huge spike in inflation right away but it’s important to remember that it’s somewhere around the next corner and you need to make sure your portfolio is prepared.

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