The federal funds rate has been held between 0% and 0.25% since December 2008. Although increasing the federal funds rate will help in combating inflation, it will also reduce the level of economic activity. At present, the unemployment rate is at 9.8%, and it is expected to peak in 2010. Considering the level of unemployment, it is believed that the Fed will not increase the rate for the ensuing 6 months. In other words, inflationary pressures are not expected to ease-off in the coming months.
Understanding Federal Funds Rate and Inflation
The Federal Open Market Committee (FOMC) is responsible for regulating the supply of money in the economy and the rate of interest, and consequently stabilizing the currency. The FOMC sets the monetary policy, and aims to achieve the aforementioned objectives by making use of the 3 tools of monetary policy, viz. open market operations, discount rate, and federal reserve requirements.
Depository institutions often borrow from each other in the overnight market and charge a rate of interest on short-term loans. This rate of interest is known as the federal funds rate and is controlled by the Federal Open Market Committee (FOMC) by trading government securities in the open market. Changes in the federal funds rate affect the short-term rate of interest, foreign exchange rates, long-term interest rates, the amount of money, credit, employment, production, and the prices of goods and services.
A decrease in the federal funds rate increases the supply of money in the economy and stimulates economic growth. However, an excessive increase in the supply of money will result in inflation. In this situation, the federal funds rate has to be increased to combat inflation.
Potential Investments During a High Inflation Period
Treasury Inflation Protected Securities (TIPS)
TIPS provide a hedge against inflation, since the underlying principal increases when there is inflation, as measured by the consumer price index, thus ensuring that the bondholder's principal is not eroded due to the fall in the purchasing power of money. The bondholder is entitled to receive a fixed rate of interest semi-annually and on maturity, he/she is paid the inflation adjusted principal. Moreover, these are safe investments (during inflation) since they are backed by complete faith of the US government.
Apartment Real Estate Investment Trust (REIT)
REITs trade like stocks and invest in real estate. The shareholder earns in the form of dividends that are believed to augment with increases in the consumer price index. This is because commercial rental properties are leased for a long period of time, and the rent is automatically adjusted to reflect inflation. When the real estate market is doing well, people invest in homes and the demand for rental apartment falls. A shaky housing market increases the demand for rental apartments, and consequently the rent increases. Thus, apartment real estate investment trusts are a good hedge against inflation.
Gold Exchange Traded Funds (ETFs)
Inflation results in an increase in the price of commodities. This is especially true in case of precious metals like gold, that act as a safe haven for consumers when the US dollar is weak. The US dollar has declined by 7% in 2009. In fact, when the US dollar was at its 15-month low, gold prices surged from USD 1,108.40 to USD 1,123.40. Since this trend is expected to continue till the US economy is on a firm footing, investors are encouraged to invest in gold Exchange Traded Funds (ETFs).
Considering that hyperinflation is a distinct possibility in the near future, such investments may help counter the erosion in the expected return on investment due to sustained increase in the aggregate price level.