PIMCO worried about inflation, recommends buying TIPS

Experts at PIMCO, which has the world's largest bond fund, said inflation is a medium and long term concern and investors should therefore consider purchasing more inflation-sensitive assets like Treasury Inflation Protected Securities (TIPS), which increase their payout when consumer inflation rises.

In the short term, inflation is not really a concern even though the Federal Reserve has recently increased the supply of U.S. dollars by significant amounts to provided liquidity during the height of the financial crisis and to stave off threats of deflation in the grueling recovery after it.

So far, these dollars have mostly remained dormant in the financial system or were used to chase certain assets. They have not caused inflation in the real economy partly due to low economic growth and liquidity trap, but also because of the usual lag between the expansion of the monetary supply and rising prices in the real economy.

However, in three to five years, they may cause inflation in the real economy, said John Cavalieri, a real return product manager at PIMCO.

Cavalieri sees multiple potential drivers of inflation risk in the medium and long term.

The depreciation of the U.S. dollar, a direct result of the expansionary monetary policy, is already causing commodity prices to rise. Eventually, the rising prices of commodities used in industrial production or by consumers (like gasoline and food) will drive up the overall cost of living.

Moreover, Cavalieri said there is a dearth of investments in recent years to expand the capability to expand the supply (mine, extract, refine, etc) of commodities. This, then, may exacerbate the above-mentioned problem.

In addition, if the U.S. dollar continues to fall versus other currencies, imports will become more expensive and exports more attractive for domestic manufacturers, so prices for American consumers will rise.

Wages and inflation are also already rising in emerging market countries that happen to be major exporters of labor-intensive goods to the U.S. The rising wages may eventually force businesses to raise the prices of those goods on U.S. consumers.

Currently, emerging market countries trying to keep their currencies from rising too much against the dollar are forced to adopted overly loose monetary policies. Because their economic growths are already robust, these policies will accelerate inflation in those countries and perhaps eventually stir up inflation in the U.S.

Lastly, the aging U.S. population will put stress on federal entitlement programs like Social Security and Medicare, which in 2010 already take up over 30 percent of the federal government budget. Cavalieri thinks policy makers may be willing to tolerate rising inflation because it is a politically palatable way to reduce the real value of that massive fiscal burden.

PIMCO thinks the low and falling inflation periods of the 1980s and 1990s are over. While it does not expect the rampant double-digit inflation of the late 1970s, PIMCO said the balance of risk is certainly shifting from disinflation to inflation in the years ahead.

PIMCO therefore recommends investors to at least consider making larger allocations to inflation-sensitive strategies and assets, including but not limited to TIPS.

Email Hao Li in New York at hao.li@ibtimes.com.