Why use 2010 to build up inflation protection?

”For the remainder of 2010, we are looking at disinflation in the U.S., the prospect of a decline in the inflation rate.  That’s because the output gap is so very large.  Going beyond 2010, there is considerably higher risk of inflation for two reasons.  The output gap will close from both ends, because of a muted recovery but also supply destruction.

Think of an airline.  When it has a demand shock, they lower prices, and lots of cheap seats are available.  That’s the disinflation effect.  Then they go park the planes in the desert.  Next thing, you and I are flying on full planes paying high fares.  Economies are slower at adjusting supply, but in coming years we will continue to see supply destruction in the U.S., meaning you’ll see inflation generated over the medium term.

The second issue, which I mentioned earlier, is public finances.  There is always a temptation for governments to try to inflate their way out of a deficit.  So even if inflation stays low, inflationary expectations will go up.  Most investors today haven’t experienced inflation, and have very little inflation protection in their portfolios.  The biggest risk is stagflation and most portfolios have very little protection. The challenge is to use 2010 to build up inflation protection for the medium term.”