Henry J. Herrmann
Chief Executive Officer
Chairman – Investment Policy Committee

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Despite record-low U.S. interest rates and the declining value of the dollar, we do not consider inflation an imminent threat.

Rather, the Federal Reserve’s willingness to maintain the Federal Funds at a near-zero rate for an extended period indicates the world’s largest central bank is fighting to prevent deflation from putting the brakes on a U.S. economic recovery. Indeed, James Bullard, president of the St. Louis Federal Reserve, recently stated that the Fed may not raise its target rate until 2012.¹

As such, we project that core inflation within the Consumer Price Index (CPI) will remain less than 2 percent during the next 12 months. This view takes into consideration four key points:

1. Although non-core items in the CPI have exhibited somewhat higher prices as the recession has eased, core items have shown little if any price increase.

This primarily reflects supply/demand issues related to China. Prices on non-core items that China consumes — food, commodities, fuel — have increased. But prices on virtually everything else — in other words, goods that China produces — have remained steady or actually fallen. Look no further than Wal-Mart, the world’s largest retailer, for proof.

Wal-Mart, by itself, represents China’s seventh-largest export market, and by some estimates, as much as 70 percent of the company’s goods originate in China. Michael Durke, chief executive officer of Wal-Mart, said this month that the company is experiencing “ongoing deflation across our businesses.”²

It’s also worth noting that food, beverages and fuel only account for slightly more than one-fifth of the CPI. And even including those goods, the CPI as a whole fell 0.2 percent in October compared with the same year ago.

2. A substantial excess supply of global labor will continue forcing downward pressure on wages.

In the U.S., labor expenses account for roughly two-thirds of all production costs. With unemployment hovering at a 26-year high near 10 percent, wages will remain under pressure for some time, and most analysts don’t see the labor market improving until mid-2010. And though some emerging markets are seeing wages rise moderately, wages compared with the developed world remain so cheap on an absolute basis that any increases barely register. Per-capita income in the U.S., for instance, remains eight times higher than per-capita income in China.

3. A lack of credit growth will further suppress prices.

Within the past few months, central banks ranging from the Bank of England to the Federal Reserve have bemoaned a lack of credit growth to consumers and small businesses. In the U.S., revolving consumer credit has declined every quarter since the fourth quarter of 2008 and fell 13.3 percent in the third quarter of 2009 compared with the prior year.

Meanwhile, commercial lending remains stagnant even amid the burgeoning economic recovery, as banks focus on recapitalizing their balance sheets.

4. Excess global production capacity has kept U.S. import prices low despite the dollar’s depreciation.

When the dollar depreciates, as it has for the past several months, inflation historically has resulted. However, with so many of the world’s manufacturing facilities remaining underutilized, manufacturers have little if any pricing power. As a result, U.S. import prices have dropped 5.7 percent in the last year.

Based on these overriding factors, our investment team and economic researchers do not consider inflation an economic risk at this time. We will continue evaluating our viewpoint as circumstances warrant.

¹ “Fed’s Bullard: Possible Fed Won’t Hike Rates Until 2012,” The Wall Street Journal, Nov. 18, 2009

² “Consumer Prices in U.S. Increased 0.3% in October,” Bloomberg, Nov. 18, 2009

Past performance is no guarantee of future results. The opinions expressed in this article are those of Mr. Herrmann and are current through December 2009. Mr. Herrmann’s views are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. Waddell & Reed Financial, Inc. is the ultimate parent company of Ivy Funds Distributor, Inc.

Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus containing this and other information on the Ivy Funds, call your financial advisor or visit us online at www.ivyfunds.com. Please read the prospectus carefully before investing.