With U.S. gasoline selling under $2 a gallon and Wall Street bond traders betting on 1.5 percent annual inflation as far as the eye can see, it may seem like the wrong time to worry about rising consumer prices.
But some voices — including a few at the Federal Reserve — are suggesting consumer inflation could take off faster than expected. If oil reverses its recent decline and wages begin to move up in response to a tighter labor market, inflation could become a factor for investors.
Some investors already are preparing for that reckoning. Some big financial firms, including BlackRock Inc., are telling their clients to hedge against inflation by buying funds that hold Treasury Inflation Protected Securities, or TIPS.
These bonds, along with consumer-facing I-Bonds, peg some of their interest to the Consumer Price Index (CPI). So as inflation speeds up, holders of those bonds earn enough interest to keep up with it.
Investors have poured $2 billion in new money to TIPS exchange traded funds in the last 16 weeks.
That may be obvious: currently, 10-year TIPS are priced, relative to plain vanilla Treasuries, in a way that would reward investors should CPI inflation over the next 10 years top 1.57 percent. The Federal Reserve is targeting 2 percent inflation in the next two years.
That makes TIPS seem like a slam dunk. With New York oil futures trading at around $38 per barrel, it is hard to imagine a world where U.S. consumer prices will not rise by more than 1.57 percent.
But think twice before you jump in with both feet — and your retirement account. The following are some of the downside risks you take when you bet on inflation with TIPS:
* Protection is limited. TIPS funds may jump quickly in value if investor sentiment starts to reflect big inflation expectations, but they rarely reward investors over time for sustained inflation. Stocks of companies that really jump during times of inflation, such as energy and real estate, may be a better bet.
* There is a worst-case scenario. Should interest rates rise faster than inflation does — expanding what economists call "real rates" — holders of TIPS may get slammed.
* You have to plan around a tax hit. You will be liable for federal income taxes on the income you earn every year, including the increase in value if the bond rates should fall.
* You might be betting wrong. Though TIPS currently are favorably priced, it will take a global economic surge and a recovery in oil prices before there is any big jump in inflation.
Linda Stern writes for Reuters.