On the question of inflation, economists -- as usual -- are divided. Investors -- as usual -- have to take the risk of choosing sides.
Some analysts say, "Yes, inflation will keep on creeping up, just as it has in the first half of this year." Others say, "No, the inflation blip is over; it may hold steady at 5 percent or so, but won't go any higher."
In this column and the next one, I'll explore these choices and what they mean for financial planning.
The case for higher inflation is put by Irwin Kellner, chief economist at Manufacturers Hanover in New York.
So far this year, prices are up sharply for industrial raw materials (because of increased demand), imported goods (because of the falling value of the dollar), and oil (because of increased use, as well as increased danger in the Persian Gulf). The full effects of these increases have not yet been felt throughout the economy.
Consumer prices are rising twice as fast as average annual earnings. This will set off big raises in government and other industries that still have cost-of-living clauses, and encourage labor unions to bargain for wage hikes. Kellner also expects an even cheaper dollar, meaning higher prices for imports and for the U.S.-made goods that compete with them.
"What we're seeing is the normal end of a business cycle," he says. Prices, wages and interest rates rise, stock market prices and business sales eventually fall, a recession arrives, and the cycle starts all over again. He sees consumer-price inflation rising to 6.5 percent in the second quarter of next year, with a mild recession following hard upon it.
Allen Sinai of Shearson Lehman Brothers thinks that business will make it safely through the election year, despite higher inflation and interest rates, but he looks for trouble in 1989.
But where Kellner sees recession, John Rutledge of the Claremont Economics Institute sees a return to stronger growth. He thinks that the jump in inflation during the first six months was a one-time price move, not to be repeated. This leads him to a forecast of lower inflation and interest rates next year.
Unlike Kellner, he thinks that the dollar will not fall any further, meaning that the prices of imported goods will not rise again. He also thinks it unlikely that workers will be able to raise their wages significantly. So he sees no significant price push from higher labor costs and increased consumer demand.
To translate your favorite forecast into action, look first to interest rates and your bank accounts. If inflation rises, interest rates will go up -- which attracts savers to short-term money-market deposit accounts.
It is appropriate to keep a little more of your money there, because rates can rise daily with the general level of interest rates.
In general, however, savers already keep too much money in these accounts "just in case" they might need it. This strategy is a money loser, because money-market deposits carry lower interest rates than certificates of deposit.
During a period of modestly rising interest rates, a better bet is a certificate of deposit with some form of inflation protection.
Look for: (1) CDs that allow your interest rate to rise over the term of the deposit; or (2) CDs that permit early withdrawal without penalty, for savers who want to invest in a higher-paying certificate. These CDs pay more current interest than money-market deposits, and give you a chance to grab higher interest rates when they come along.
You are also better off with a CD if interest rates do not rise, because of their rate advantage over money-markets. If your bank doesn't offer rising-rate CDs, check the competition. Or, buy one-year CDs.
Another question for bank customers: Should you take a fixed-rate or an adjustable-rate mortgage (ARM)? Analyze it this way:
If you thought mortgage rates would rise substantially for several years, you'd want a fixed-rate loan. But this result isn't expected.
If rates will stay level-to-down, you'd want an ARM, because it is so much cheaper.
You'd also want an ARM if interest rates move up over the next year or so and then subside in the next recession. You'd start out paying less than for a fixed-rate loan; for a year or so you might pay more. But then you'd go back to paying less again.ENDQUA