Even When Low, Inflation Can Hurt

NEW YORK (TheStreet) -- Inflation fears have subsided as the economic outlook has darkened once again. This is boosting the dollar and sending gold prices lower while many observers are pushing the Federal Reserve to take more drastic monetary policy actions to support the economy as a gridlocked Congress stands idle.

Even if policymakers overlook the threat of inflation, though, investors shouldn't forget the damage that even low-level inflation can have on their holdings -- particularly at a time when interest rates are at record lows.

The Consumer Price Index, which is the official reading of inflation in the U.S., has increased by 1.7% over the last 12 months through May, according to the U.S. Bureau of Labor Statistics. That marks a steady decline from the 3.9% peak last September, and it's a historically low level. Meanwhile, Federal Reserve Chairman Ben Bernanke said Wednesday that the Fed's Open Markets Committee foresees prices remaining stable with the inflation rate at or below the central bank's 2% target.

The market appears to agree, with futures prices showing a decline in expectations for inflation over the next five years. All this provides fodder for those who have argued that the U.S. economy is facing a deflationary predicament, dismissing arguments from opposing camps that the extraordinarily accommodative stance of the Federal Reserve in response to the financial crisis and its aftermath will spark an outbreak of inflation.

Still, when investors are scrambling to buy 10-year Treasuries at a yield of less than 1.7%, I think we can all agree that even modest inflation at a rate of 1.7% is devastating. Investors that hold a 10-year Treasury to maturity under these circumstances are facing the unwelcome prospect of suffering a long-term decline in the value of their holdings in real terms. Inflation is completely wiping out their yield.

Sure, yields on Treasuries could go lower, sending prices higher and giving holders the prospect of a capital gain if they're willing to sell. But we're already at record lows. How much lower can we go? I would submit that buying Treasuries and other investment grade bonds at current prices is not a "buy-low, sell-high" strategy -- quite the opposite, actually. And let's bear in mind that the whole point of investing is to buy assets at a low price and sell them at a higher price.