American Investment Services, Inc.

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August 2014 – The True Cost of Price Inflation

In a world of fiat currencies the threat of unexpected price inflation is always with us. While many articles and commentators decry inflation, they do so for the wrong reasons because they tell only a partial story. They frequently ignore the fact that while many suffer from rising price levels, others gain. Make no mistake: inflation is bad.

But the true cost of inflating is that the actions we take to minimize its impact are not offset by gains elsewhere. Inflation exacts costs but also bestows benefits. If you buy a fixed income security (a bond), and subsequent inflation unexpectedly rises, you will receive fixed nominal interest payments that have lost purchasing power. But the borrower who issued the bond will gain because these interest payments are made with depreciating dollars.

These effects are exactly offsetting, so from an economic perspective there is no loss of efficiency. Conversely, if you are a homeowner with a fixed rate mortgage you get to pay back your debt with depreciating dollars. But the lender suffers by an exactly offsetting amount, so again efficiency is unaffected.

In times of pronounced inflation, we take actions to reduce its impact. For example we carry less cash, which means fewer spontaneous purchases, more trips to the ATM, etc. In the economist’s ledger these count as costs. But because there are no offsetting gains for anyone these costs are considered a “deadweight loss” in economic jargon, and therefore inefficient. Similarly, firms may maintain lower cash balances during inflationary times, and this lack of liquidity could force a costly recapitalization; again, because there is no offsetting gain to anyone, this would be a deadweight loss. It has been estimated that deadweight losses generated by a year of 3 percent inflation in the U.S. add up to about $18 billion, or about $60 per American.

We have frequently explained that inflation effectively forces investors to assume greater risk by purchasing stocks instead of holding cash or short-term bonds, because stocks have better prospects for outpacing inflation over the long term. But this entails a portfolio with far more volatile returns. The enclosed article The Tradeoff: Preserving Capital or Preserving Purchasing Power describes this trade-off in detail.

Our portfolio recommendations are designed to help investors manage this trade-off effectively, by offering a variety of portfolio allocation plans that can be adopted to meet your particular tolerance for risk, including the risk of unexpected inflation.

Also in This Issue:

Riding Out the Storm
Economics, Efficiency, and Investing
The Tradeoff: Preserving Capital or Preserving Purchasing Power
The High-Yield Dow Investment Strategy
Recent Market Statistics
The Dow-Jones Industrials Ranked by Yield
Asset Class Investment Vehicles