Make 7% Taming Inflation, Deflation and Stagflation

President Harry Truman once said he wanted to hire a one-armed economist. When asked why, he replied, so the economist couldn't say "on the other hand."

For Barack Obama, finding a one-armed economist is even more pressing. Obama is faced with deciding which limb of the three-armed monster--deflation, inflation or stagflation--could be most damaging to the nation's well-being. Unfortunately, we income investors face the same dilemma.

Failure to accurately decipher the coming economic storm could be injurious to your financial health. And seldom has the situation been so hard to read.

Deflation
Home prices have fallen an average -18% since 2008. GDP fell -6.3% in the fourth quarter of 2008 and another -5.5% in the first quarter of 2009. And the Consumer Price Index (CPI) is down more than -5.5% in the last six months. That's deflation!

If you're like most Americans, the value of your home has fallen sharply. Your stocks are down in conjunction with the S&P 500, which lost nearly -40% in 2008. And you are receiving less dividend income as dividend stalwarts such as General Electric (NYSE: GE) slashed payouts for the first time in decades.

If deflation alone was the issue, you could protect your portfolio by hunkering down in the most defensive bonds and stocks. But it's not.

Inflation
To combat deflation, the U.S. government, through stimulus spending and programs such as TARP and TALF, has by some estimates injected $12.8 trillion dollars into the economy. That's roughly $42,000 for every person in America.

The effect of all this spending could be massive inflation as the dollar loses value and prices rise to offset the effects. Massive inflation can be devastating for your investments. Bonds you own will decline sharply in value. The fixed income stream you receive will lose purchasing power. Most stocks also will lose value except those that sell commodities.

Stagflation
Finally, some economists are predicting the return of stagflation, that unholy relic from the seventies. This combination of slow or stagnant economic growth and high inflation combine the worst of two worlds and can be disastrous for your investments.

TIPS to the Rescue
Okay, that's the bad news. The good news is that you can actually protect your portfolio from this nasty trifecta of deflation, inflation or stagflation scenarios. Fortunately, there's a simple four-letter solution: TIPS (Treasury Inflation-Protected Securities).

TIPS are linked to changes in inflation as measured by the Consumer Price Index (CPI). The principal value of the TIPS bonds is adjusted every six months to the CPI. When the CPI moves higher, the principal increases. The interest you receive on the bonds is a percentage of the principal, so it also increases. This increase, in turn, raises the bonds' yield and provides you protection against inflation.

If deflation persists, you are still guaranteed your principal, or the par value, of the bonds at maturity. So, you are also protected against deflation.

Why not wait until inflation actually kicks-in to invest in TIPS? Right now, TIPS are undervalued. The 10-year Treasury bond is yielding 3.2% and the 10-year TIP 1.5%. That assumes a 1.7% rate of inflation over the next decade, one which given all the monetary stimulus appears ridiculously low. In such an environment, the value of your TIPS or TIP fund can rise dramatically.

You can buy and sell TIPS from your broker or directly from the government by going to www.TreasuryDirect.gov. The advantage of holding individual TIPS is you get your principal when they mature. The trade off is they are only yielding less than 2%.

For a better yield and a diverse portfolio of TIPS that mature at different times, you may want to look at a fund. Several funds invest in TIPS, and they generally yield in the 5-7% range, but there are some out there as high as 12%.

Not only are times uncertain, but the possible outcomes vary drastically in consequence to your portfolio. Fortunately, there is a way that you can earn the returns you need while properly minding risk. The age of TIPS has arrived and you can still get in before the crowds.

Income Notes

The Producer Price Index, which tracks how much it costs for manufacturers to make things, rose +1.8% last month. Analysts had foreseen a +1.0% advance.

Higher energy prices accounted for most of the increase. June's gasoline prices were +18.5% higher than May's. The energy segment of the index rose +6.6%, after a +2.9% rise the month before.

-- Brad Briggs
 Research Staff

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