Fund managers are increasingly embracing a scenario of low inflation and interest rates accompanying a sharp economic recoveryAs reports of a major economic revival pour in, investor sentiment is quickly swinging from unduly bleak to overly exuberant. The gaudy profits Wall Street analysts now forecast for next year ahead might be the most conspicuous example of the excess. But banking on tame inflation for the foreseeable future is the other part of the overly rosy economic picture now being painted.

Low inflation and interest rates are expected to accompany the sharp recovery if a fast-growing segment of Wall Street is to be believed, as incongruous that may seem. And yet a growing number of fund managers "painted a picture of an ideal investment environment," according to a Bank of America/Merrill Lynch survey. A record 32% of fund managers -- the highest since the survey began in February of 2008 -- now envision a "Goldilocks" scenario where inflation remains tepid but growth picks up quickly, up sharply from 21% just a month ago.

"Clearly the markets are in a utopia-type environment," Morgan Stanley credit strategist Gregory Peters wrote recently about the outlook for heady growth but benign inflation.

Where Is the Skepticism?

But investors should be highly skeptical of this dreamlike scenario. Not only are the prospects of corporate profits reaching new highs unlikely amid an economy that, while clearly on the mend, still faces major issues. But inflation and interest rates may also march upwards from record lows faster than the complacent consensus envisions. And higher borrowing costs for businesses and consumers would create a substantial hurdle for the economy.

It's true that many measures of inflation have remained tame and even shown signs of decelerating as of late. Consumer prices rose just 1.3% in February excluding volatile food and energy costs, the smallest 12-month gain in six years and below the standard 2% before the downturn. Towering unemployment rates and pressures on wages, meanwhile, keep the prices in check and give the Federal Reserve little reason to jack rates too quickly into a recovery.

But that could all change very quickly as the record amounts of liquidity injected into the financial system is rapidly put into circulation and leads to rising prices given a strong recovery. Moreover, the anticipation of rising rates tends to be self-fulfilling as investors demand higher rates to stem off what they predict to be the prospects of inflation.


Signs of Creeping Inflation

And anecdotal evidence of inflation is grabbing more and more attention. Raymond James strategist Jeff Saut, for example, reports that a manufacturer is passing on rapidly rising input costs driven by blistering overseas growth and commodity prices in what may well be representative of broader developments.

Traditional inflation hedges like gold, meanwhile, have demonstrated remarkable resilience in the face of a strengthening dollar. That suggests that pockets of investors are vigilant about inflation prospects, even if the consensus remains largely dismissive.

Some like Philadelphia Fed President Charles Plosser are even arguing that the recent benign readings of inflation may be unduly distorted by a ravaged housing market. Consumer prices were actually up a sharp 3.4% in February excluding the cost of shelter, Plosser recently told The Wall Street Journal.

Taking a More Hawkish Stance


"As the economy improves and as lending picks up, the longer-term challenge we face will not be worrying about inflation being too low," he said. "The risk is really to the upside of inflation over the next two to three years."

Plosser joins Kansas City Fed president Thomas Hoenig, who has long flagged combating perceptions of rising inflation as key, in taking a more hawkish stance.

Any evidence of rising prices, then, could collide with the lax stance that many are expecting the Fed to maintain. Despite signs that an economic recovery is materializing, 42% of fund managers in the Bank of America/Merrill Lynch survey do not anticipate a rate hike in the year ahead compared to 38% last month.

But far short of Fed tightening, perceptions of rising prices is all that is needed to send interest rates moving higher. And perceptions can change very rapidly. The latest wave of euphoria sweeping aside the prior gloom serves as a vivid reminder of this.

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