The Time to Tame Inflation Is Well Before It Strikes

• By JASON ZWEIG

Insurance is often most worth having when it seems least necessary.

Right now, you might feel you don't need any insurance against a rise in the cost of living. Inflation, as measured by the Consumer Price Index, is running at negative-1.3% over the past 12 months; with oil and real estate down drastically, there are few signs of rising prices in daily life.

Heath Hinegardner

But the cost of living mightn't fall for much longer. So it is a good time to look at inflation insurance, in the form of U.S. Treasury Inflation-Protected Securities, or TIPS. The principal value of TIPS increases or decreases with the cost of living. Unlike normal bonds, TIPS don't get hammered when inflation rises.

There is a historic tug of war under way between inflation and deflation, with the federal government borrowing $1.9 trillion in the past 12 months even as prices of many goods and services continue to fall.

"Inflation uncertainty is probably wider today than at any time before the financial crisis," says John Hollyer, co-manager of the $22 billion Vanguard Inflation-Protected Securities fund. "So having that protection in your portfolio is still valuable."

Even when prices are going up, many people fall prey to what is called "money illusion" -- the tendency to overlook the corrosive effects of a rising cost of living. You would probably rather have a 2% raise in a time of 4% inflation than a 2% pay cut in a time of zero inflation. The pay raise feels more positive and will make you happier than the pay cut -- even though both alternatives are economically identical, leaving you 2% poorer after inflation.

So if people are prone to this fallacy, why are TIPS funds hot? Through May, inflation-protected bond funds accounted for $10.4 billion, or 11%, of all the new money that flowed into stock and bond funds this year.

I worry that at least some buyers of these funds may be doing the right thing for the wrong reason. It seems implausible that, at the very moment when inflation seems to be least threatening, investors would get a sudden collective urge to protect against it. Instead of trying to protect against future inflation, many of these new investors may be chasing past performance. TIPS have gained 5.3% in 2009, versus a 4.4% loss on Treasurys overall, according to Vanguard. But, says Gang Hu, co-manager of Pimco Real Return fund, "a TIPS fund should be something you invest in for insurance, not for income."

Why? First of all, history suggests that deflation is highly unlikely to persist in the long run. Even in the onset of the Great Depression, when the government barely borrowed at all, deflation -- though severe -- lasted only from 1930 through 1932. With Uncle Sam now on a borrowing binge, we could easily end up with too much money chasing too few goods -- the very definition of inflation.

Second, the cost of living might rise faster than you expect; TIPS are priced as if inflation will run at an average rate over the next five years of no higher than 1%, and then will rise to 2.5% annually over the following five years. If those expectations are too low, TIPS will protect you.

TIPS offer baseline insurance against a rise in all the costs of living. However, TIPS aren't customizable. The official inflation basket consists of housing costs (43%), food (16%), transportation (15%), health care and recreation (6% each), apparel (4%) and education, communication and "other" (3% apiece). If the basket of goods and services that you pay for is significantly different from the CPI, then TIPS won't fully insure you.

So think about what makes up your personal inflation mix. If you are unlikely to qualify for financial aid, then the costs of educating your children could wildly exceed 3% of your expenses. So you might consider a prepaid college tuition program like the Independent "529 plan," assuming you are confident your child will be able to get into one of the participating schools. If you have aging parents, an assisted-living facility already costs an average of $3,000 a month; a semiprivate room in a nursing home runs more than $5,600 monthly. You can partially hedge against those rising costs with a stake in an exchange-traded fund like Vanguard Health Care or iShares Dow Jones U.S. Healthcare Providers Index.

Those hedges won't be perfect, either, but you need some riders to the general insurance policy that TIPS provide. You are the only one who can make sure you are fully insured.

What If Israel Strikes Iran?

The mullahs would retaliate. But things would be much worse if they had the bomb.

JOHN R. BOLTON

Whatever the outcome of Iran's presidential election tomorrow, negotiations will not soon -- if ever -- put an end to its nuclear threat. And given Iran's determination to achieve deliverable nuclear weapons, speculation about a possible Israeli attack on its nuclear program will not only persist but grow.

So what would such an attack look like? Obviously, Israel would need to consider many factors -- such as its timing and scope, Iran's increasing air defenses, the dispersion and hardening of its nuclear facilities, the potential international political costs, and Iran's "unpredictability." While not as menacingly irrational as North Korea, Iran's politico-military logic hardly compares to our NATO allies. Central to any Israeli decision is Iran's possible response.

David Klein

Israel's alternative is that Iran's nuclear and ballistic missile programs reach fruition, leaving its very existence at the whim of its staunchest adversary. Israel has not previously accepted such risks. It destroyed Iraq's Osirak reactor in 1981 and a Syrian reactor being built by North Koreans in 2007. One major new element in Israel's calculus is the Obama administration's growing distance (especially in contrast to its predecessor).

Consider the most-often mentioned Iranian responses to a possible Israeli strike:

1) Iran closes the Strait of Hormuz. Often cited as Tehran's knee-jerk answer -- along with projections of astronomic oil-price spikes because of the disruption of supplies from Persian Gulf producers -- this option is neither feasible nor advisable for Iran. The U.S. would quickly overwhelm any effort to close the Strait, and Iran would be risking U.S. attacks on its land-based military. Direct military conflict with Washington would turn a bad situation for Iran -- disruption of its nuclear program -- into a potential catastrophe for the regime. Prudent hedging by oil traders and consuming countries (though not their strong suit, historically) would minimize any price spike.

2) Iran cuts its o wn oil exports to raise world prices. An Iranian embargo of its own oil exports would complete the ruin of Iran's domestic economy by depriving the country of hard currency. This is roughly equivalent to Thomas Jefferson's 1807 embargo on American exports to protect U.S. shipping from British and French interference. That harmed the U.S. far more than the Europeans. Even Iran's mullahs can see that. Another gambit with no legs.

3) Iran attacks U.S. forces in Iraq and Afghanistan. Some Tehran hard-liners might advocate this approach, or even attacks on U.S. bases or Arab targets in the Gulf -- but doing so would risk direct U.S. retaliation against Iran, as many U.S. commanders in Iraq earlier recommended. Increased violence in Iraq or Afghanistan might actually prolong the U.S. military presence in Iraq, despite President Barack Obama's current plans for withdrawal. Moreover, taking on the U.S. military, even in an initially limited way, carries enormous risks for Iran. Tehran may believe the Obama administration's generally apologetic international posture will protect it from U.S. escalation, but it would be highly dangerous for Iran to gamble on more weakness in the face of increased U.S. casualties in Iraq or Afghanistan.

4) Iran increases support for global terrorism. This Iranian option, especially stepping up world-wide attacks against U.S. targets, is always open. Assuming, however, that Mr. Obama does not further degrade our intelligence capabilities and that our watchfulness remains high, the terrorism option outside of the Middle East is extremely risky for Iran. If Washington uncovered evidence of direct or indirect Iranian terrorist activities in America, for example, even the Obama administration would have to consider direct retaliation inside Iran. While Iran enjoys rhetorical conflict with the U.S., operationally it prefers picking on targets its own size or smaller.

5) Iran launches missile attacks on Israel. Because all the foregoing options risk more direct U.S. involvement, Tehran will most likely decide to retaliate against the actual attacker, Israel. Using its missile and perhaps air force capabilities, Iran could do substantial damage in Israel, especially to civilian targets. Of course, one can only imagine what Iran might do once it has nuclear weapons, and this is part of the cost-benefit analysis Israel must make before launching attacks in the first place. Direct Iranian military action against Israel, however, would provoke an even broader Israeli counterstrike, which at some point might well involve Israel's own nuclear capability. Accordingly, Iran's Revolutionary Guards would have to think long and hard before unleashing its own capabilities against Israel.

6) Iran unleashes Hamas and Hezbollah against Israel. By process of elimination, but also because of strategic logic, Iran's most likely option is retaliating through Hamas and Hezbollah. Increased terrorist attacks inside Israel, military incursions by Hezbollah across the Blue Line, and, most significantly, salvoes of missiles from both Lebanon and the Gaza Strip are all possibilities. In plain violation of U.N. Security Council Resolution 1701, Iran has not only completely re-equipped Hezbollah since the 2006 war with Israel, but the longer reach of Hezbollah's rockets now endangers Israel's entire civilian population. Moreover, Hamas's rocket capabilities could easily be substantially enhanced to provide greater range and payload to strike throughout Israel, creating a two-front challenge.

Risks to its civilian population will weigh heavily in any Israeli decision to use force, and might well argue for simultaneous, pre-emptive attacks on Hezbollah and Hamas in conjunction with a strike on Iran's nuclear facilities. Obviously, Israel will have to measure the current risks to its safety and survival against the longer-term threat to its very existence once Iran acquires nuclear weapons.

This brief survey demonstrates why Israel's military option against Iran's nuclear program is so unattractive, but also why failing to act is even worse. All these scenarios become infinitely more dangerous once Iran has deliverable nuclear weapons. So does daily life in Israel, elsewhere in the region and globally.

Many argue that Israeli military action will cause Iranians to rally in support of the mullahs' regime and plunge the region into political chaos. To the contrary, a strike accompanied by effective public diplomacy could well turn Iran's diverse population against an oppressive regime. Most of the Arab world's leaders would welcome Israel solving the Iran nuclear problem, although they certainly won't say so publicly and will rhetorically embrace Iran if Israel strikes. But rhetoric from its Arab neighbors is the only quantum of solace Iran will get.

On the other hand, the Obama administration's increased pressure on Israel concerning the "two-state solution" and West Bank settlements demonstrates Israel's growing distance from Washington. Although there is no profit now in complaining that Israel should have struck during the Bush years, the missed opportunity is palpable. For the remainder of Mr. Obama's term, uncertainty about his administration's support for Israel will continue to dog Israeli governments and complicate their calculations. Iran will see that as well, and play it for all it's worth. This is yet another reason why Israel's risks and dilemmas, difficult as they are, only increase with time.

Mr. Bolton, a senior fellow at the American Enterprise Institute, is the author of "Surrender Is Not an Option: Defending America at the United Nations and Abroad" (Simon & Schuster, 2007).