As the Federal Reserve's monetary easing has expanded its balance sheet to more than $3 trillion, the central bank has also assured that it possesses the right tools and the fortitude to potentially combat a resultant surge in inflation. If one were to assume the effectiveness of these tools and that the Fed still has Volcker-like¹ credibility in tackling rising prices, then recent inflation figures could be a decent guide as to the pace of future inflation.

While the Fed has pledged to maintain price stability, the United States is only one of 38 countries that are said to be currently pursuing zero or negative real interest rate policies.² The global breadth of the monetary easing, in what some descriptions refer to as a "currency war," has given investors reason to fear accelerating inflation. But this does not mean that they need to rotate away from fixed income. Rather, investors (along with their financial advisors) might identify which fixed-income strategies they believe might efficiently protect their purchasing power from an inflationary threat.

Recent U.S. inflation figures reflect the subdued pace of economic growth with the Fed anticipating core inflation rates of 1.75% and 1.80% in 2013 and 2014, respectively.³ Looking further out, the breakeven rates on Treasury Inflation-Protected Securities (TIPS), as of early February 2013, indicated an inflation rate of 2.35% in five years.⁴ These measures remain below the 30-year average U.S. inflation rate of 2.9% and the 2.5% threshold that the Fed recently indicated could require a change in monetary policy.⁵

However, the expansion of the Fed's balance sheet and the corresponding increase in bank reserves is difficult to overlook. Although growth in the largest segment of bank lending remained relatively tame, at 2.6% in 2012⁶ (not adjusting for inflation), if more of these reserves flowed into the economy, they could result in a significant amount of newly created money chasing a relatively stagnant amount of goods and services. The Fed appeared to address this threat of escalating prices when it outlined its methods to unwind policy accommodation, suggesting that the ability to pay interest on its holdings of bank reserves could prevent too much of this money from flowing into the economy too quickly.⁷

Yet, the Fed is not alone in its vast accommodation, and there are signs that overseas governments are increasingly influencing monetary policy decisions. The most glaring instance of government intervention has occurred with Japan's new policy regime, but high-profile comments about managed exchange rates elsewhere have provoked fears of additional fronts in a currency war. And if central banks in countries pursuing aggressive policy accommodation lose their independence, it is unclear if policymakers will develop the tools, or desire, to tackle a surge in inflation.

Hedging Inflation versus Hedging Its Symptoms
The concept of global inflation that could affect domestic prices might lead investors to consider commodities or real estate as hedges against faster inflation. But these could be viewed as hedges to the symptoms of rising prices, rather than protection from inflation itself and from the potential policy responses.

In terms of commodities, investors would need to decide which commodity might provide the closest correlation to inflation. If they choose incorrectly, they might receive very little inflation protection, while possibly exposing themselves to volatility that has historically exceeded that of equities.⁸ A similar situation could exist with real estate-related assets, such as real estate investment trusts, which have experienced greater historical volatility than even commodities.⁹

Investors might view TIPS as a more stable inflation hedge. Yet, if long-term interest rates rise as a consequence of accelerating inflation, TIPS could encounter heightened volatility considering that the benchmark U.S. TIPS index had a duration¹⁰ of 8.8 years, as of February 8, 2013.¹¹ In addition, the yields on 10-year TIPS were negative (as of early February), and even if the rate of inflation accelerates, there would be only a minimal increase in the income received by investors because the principal of a TIPS issue adjusts for inflation, rather than the coupon.¹²

Instead, if investors believe that the Fed might eventually lift interest rates to mitigate rising prices, then investors might look to limit their duration exposure through short-duration credit strategies or, essentially, eliminate their duration exposure through a floating-rate loan strategy.

In addition to the potential for a positive level of real income, the coupons on floating-rate loans are based on short-term interest rates thus can increase if these rates were to move higher. The short-term coupons also mean that these assets have minimal durations, which means that they would be subject to relatively limited volatility if long-term interest rates encountered some turbulence.

A short-duration credit strategy also has the potential for a positive level of real income, and it may present a step up in credit quality when compared to loans. Although rising rates could affect this strategy, its relatively short duration could indicate that it would likely outperform strategies with greater interest-rate sensitivity.

Finally, investors could seek exposure to the actual rate of inflation through instruments linked to the Consumer Price Index,¹³ which could provide the potential for capital appreciation if inflation rises notably. When these assets complement a portfolio of short-term credit securities, the potential for a relatively attractive stream of income exists as well. Although these assets could be negatively affected if the inflation rate were to decline, this could be offset by the theoretical appreciation of a portfolio's other fixed-income holdings.

These strategies might provide investors more accurate protection against rising prices and the potential solutions to mitigate inflation. This focus could be an important aspect, considering that global central banking appears to have entered unfamiliar territory on a couple of different levels. One is that the scale of the monetary easing is unprecedented when central banks hold trillions of dollars of assets on their balance sheets. And another is that the easing has global breadth, where central bankers no longer appear to be the only ones making the decisions.