Gold key as Fed risks overshooting inflation target

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Inflation is still by no means going gangbusters, but nascent signs that prices are starting to rise should have investors thinking about gold as a portfolio hedge.

Crude oil has rallied by about 50% since its February lows; the S&P/Case-Shiller housing-price index posted a 5.7% rise in January; and the Consumer Price Index for February showed that core inflation (minus food and energy costs) increased by 2.3% year-over-year for a post-Great Recession high. The 2% threshold is key because thats the Federal Reserves stated inflation target.

Several regional presidents of the central bank have been warning of rising prices, most recently John Williams of the San Francisco branch, and their caveats on inflation have become all the more imperative given Fed Chairwoman Janet Yellens overtly dovish speech before the Economic Club of New York on Tuesday.

The recent data reinforce my expectation that inflation is on track to move back to 2% over the next two years, Williams said in Singapore this week.

Oil could light inflationary fire: Some big investment firms also are issuing analyses urging clients not to underestimate inflation. It is naveto ignore the potential risk that themarket could be surprised by higherinflation rates, wrote Investec Asset Managements Philip Saunders.

Our modelssuggest inflation and wages will befirm going forward and our commodityteam believes that robust oil demandand a material decline in oil supply willprovide support to the oil price.

If thereis a more sustained oil price recovery,consistent with our commodity teamsforecast of approximately US$60 perbarrel, there is a meaningful risk thatinflation could even overshoot to theupside.

Gold, TIPS for diversifiers: And the Pacific Investment Management Co., or PIMCO, also told its clients that inflation could be back on the move, with strategist Anthony Crescenzi recommending Treasury Inflation-Protected Securities, or TIPS, to offset rising prices. Markets are not fully priced for this reflation idea, he said.

But TIPS arent the only weapon against inflation. Capital Economics has attributed golds 16% rise this year at least partially to growing inflation expectations.

BlackRock also thinks gold is a good bet. Stabilizing oil prices and a tighter labor market could contribute to rising actual, and expected, U.S. inflation, said its global chief investment strategist, Richard Turnill. We like inflation-linked bonds and gold as diversifiers.

Stagflation nightmare ahead?: Of course, there is another potential end result besides inflation or deflation (recession), and thats stagflation, in which rising prices co-exist with slow growth and high unemployment. The U.S. suffered from stagflation in the 1970s, and certain similarities exist between then and now.

For one, U.S. growth is relatively stagnant, stuck in the 2% range or even lower, according to the latest quarterly forecast from the Atlanta Fed. And while the official unemployment rate is 4.9%, the labor-participation rate is near record lows, with 102.5 million working-age Americans currently lacking a job.

Stagflation is on the radar of Bank of America, which recently issued a note saying clients should at least prepare for that eventuality.

While it is not our base case, investors may want to hedge the tail risk of the economy experiencing elements of stagflation realized as rising inflation during stagnating growth, noted BofAs global rates and currencies research team.

Gold outperforms in stagflation: So how should investors prepare for this eventuality? MarketWatch wrote in summarizing the note. According to Bank of Americas historical analysis of market trends, gold, oil and U.S. Treasurys tend to outperform during periods of stagflation, while equities tend to underperform.

So equity bulls, beware: If first-quarter GDP disappoints, as Bank of America expects, one might want to consider buying gold or Treasurys as a hedge.

Given that several current U.S. GDP estimates are running at under 1%, maybe Bank of America is onto something. In any case, should the Fed err and overshoot its 2% inflation target, investors might be happy that they prepared with gold and silver bullion plus rare coins.