Inflationary surge or deflationary slump? Five questions with Roger Early

Despite the fragile nature of the U.S. economic recovery, inflation appears to be ticking up, raising concerns about a drawn-out inflationary spiral. How realistic are these concerns? What are some of the factors putting pressure on prices today, not just in the U.S., but internationally?

Roger Early, head of fixed income investments and co-chief investment officer for total return fixed income strategies, considers these questions while discussing his team’s inflation expectations.

Click on each question to read its answer or scroll down the page.

Q: The Fed has massively pumped up its balance sheet in recent years. Why hasn't this expansion resulted in notable inflation?

A: In our view, it helps to look beyond balance sheet expansion at broad money supply statistics. The science behind these statistics can get complicated, but what we generally see is that expansion of the money supply has only happened in one place: at the point where the Fed actually prints money. Beyond that, the net effects on the nation's money supply have been relatively limited.

In the past, banks would use newly created cash reserves to write loans, gradually multiplying the amount of money circulating throughout the economy. Under today's conditions, however, this “multiplier effect” is broken. It's a crucial link — our economy depends on bank loans to stimulate commerce — and, in our opinion, inflation is not likely to take hold without it.

Growing balance sheet for Fed

Data: The Federal Reserve, as of June 2011.

Slowdown in the velocity of money

*Velocity rates in this chart are based on a measure of the money supply that economists refer to as M2. It includes (but is not limited to) the following forms of money: currency in circulation, commercial bank deposits, overnight repurchase agreements between commercial banks, savings accounts, and time deposits under $100,000.

Velocity measurements shown above are based on seasonally adjusted quarterly readings.

Data: Federal Reserve Bank of St. Louis, as of June 2011.

Q: For a long time, investors have believed that expansionary monetary policy aggravates the risks of inflation. Do you think this an outdated piece of conventional wisdom?

A: We do. We believe investors should not expect the connection to be as profound as it might have been at one time. Not to belabor the point, but we think investors should keep in mind that monetary easing on a grand scale has not yet been tested under today's conditions. Therefore, any expectation of historical cause-and-effect relationships might be somewhat naive.

Q: If the money supply isn't a dominating factor, what is?

A: The way we see it, this is a demand story much more than it is a money supply story. This is particularly true in developing economies where secular trends could put significant pressure on prices as tens of millions of people join the middle class.

In China, for instance, a profound shift in the labor market is under way as tighter job markets are allowing Chinese laborers to be more discriminating in the types of work they seek (and the wages they're willing to accept). It's hard to overstate the potential effects of such a dramatic change in the country's labor picture. One outcome is almost certain: more people with more income are going on more shopping trips.

Q: What about demand levels here in the U.S.?

A: Given the stubborn output gap that persists here at home, we expect continued softness in a key inflation driver: wages. Sure, similar levels of resource slack can be found in other economies (including some in Europe), but we expect wage pressure to have a muted effect on price levels here in the U.S. for quite some time.

Q: How is your outlook affecting your team's portfolio allocation decisions?

A: I'll go back to talking about emerging economies for a minute because they figure prominently in our outlook. We believe commodity-led inflation could take place largely in emerging markets because commodity prices are larger contributors to overall inflation in those fast-growing economies. This includes regions like Asia and South Africa, and specific nations like South Korea and Brazil.

Simply put, general price levels in these parts of the world tend to show significant correlation with commodities, given their relatively high rates of economic growth and steady demand for commodity-related materials. This is not to say that we're making a blanket bet across all types of commodities, because not all commodity prices follow the same trend. Further, current correlation does not necessarily mean continued correlation. 

With the aforementioned in mind, we generally favor increased exposure to inflation-linked bonds issued by countries outside the U.S. When it comes to investing in inflation-linked securities, we're finding that bonds issued in certain regions overseas are compensating investors well, particularly when compared to inflation-protected bonds issued domestically.

Today's circumstances also affect how we view bonds with respect to maturity. Given that global inflation appears to be trekking upward in the near term, we believe it's prudent to emphasize bonds of intermediate maturities. We can't say with certainty what will happen to inflation in the distant future, so we're currently less compelled to move toward longer maturities.

Ways to alleviate the effects of inflation:

The views expressed were current as of June 6, 2011, and are subject to change at any time.

Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting our fund literature page or calling 800 362-7500. Investors should read the prospectuses and the summary prospectuses carefully before investing.


Investing involves risk, including the possible loss of principal.

Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt.

The Fund may also be subject to prepayment risk, the risk that the principal of a fixed income security that is held by the Fund may be prepaid prior to maturity, potentially forcing the Fund to reinvest that money at a lower interest rate.

A rise/fall in the interest rates can have a significant impact on bond prices and the NAV (net asset value) of the fund. Funds that invest in bonds can lose their value as interest rates rise and an investor can lose principal.

The Fund may experience portfolio turnover in excess of 100%, which could result in higher transaction costs and tax liability.

The Funds may invest in derivatives, which may involve additional expenses and are subject to risk, including the risk that an underlying security or securities index moves in the opposite direction from what the portfolio manager anticipated. A derivative transaction depends upon the counterparties’ ability to fulfill their contractual obligations.

International investments entail risks not ordinarily associated with U.S. investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations.

Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.

These materials represent the views and opinions of the author(s) regarding the economic conditions, asset classes, securities, issuers or financial instruments referenced herein. Any reproduction of these materials, in whole or in part, or the divulgence of any of the contents thereof, without prior consent of Delaware Investments is prohibited. Certain information contained herein has been obtained from sources that Delaware Investments believes to be reliable as of the date presented; however Delaware Investments cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. Delaware Investments has no obligation to update any or all of such information; nor do we make any express or implied warranties or representations as to the completeness or accuracy or accept responsibility for errors. These materials are not intended as an offer or solicitation with respect to the purchase or sale of any security or other financial instrument or any investment management services and should not be used as the basis for any investment decision. No liability whatsoever is accepted for any loss (whether direct, indirect, or consequential) that may arise from any use of the information contained in or derived from this report. Delaware Investments and its affiliates may make investment decisions that are inconsistent with the recommendations or views expressed herein, including for proprietary accounts of Delaware Investments or its affiliates.

The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or funds to particular clients or prospects. No determination has been made regarding the suitability of any securities, financial instruments or funds for particular clients or prospects. For any securities or financial instruments mentioned herein, the recipient(s) of this report must make its own independent decisions.

Conflicts of Interest: Delaware Investments and its affiliates may have investment advisory or other business relationships with the issuers of securities referenced herein. Delaware Investments and its affiliates, officers, directors and employees may from time to time have long or short positions in and buy or sell securities or financial instruments referenced herein. Delaware Investments affiliates may develop and publish research that is independent of, and different than, the information contained herein. Delaware Investments personnel other than the author(s), such as sales, marketing, and trading personnel, may provide oral or written market commentary or ideas to clients of Delaware Investments or prospects or proprietary investment ideas that differ from the views expressed herein. Additional information regarding actual and potential conflicts of interest is available in Part II of Form ADV for Delaware Management Business Trust.