Remember Inflation?

Mohamed El-Erian, the other genius at PIMCO, has this intriguing thought in the latest Barron's:

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.

He sees inflation as inevitable in the medium term for two reasons. One is that governments running large deficits (as is the U.S.) will always be tempted to inflate and even if they don't, investors will expect them to, so that inflationary expectations will go up. The other is that unemployment will stay high for the foreseeable future and the Fed will be hesitant to be too hawkish lest they hurt the economy and worsen the employment situation.

Rising inflation expectations combined with a less than totally committed Fed will most likely result in some serious inflation at some point down the road. As Mr. El-Erian suggests, adding some TIPS to one's portfolio this year would qualify as a prudent move.