The best tools to fight inflation

by Pop on August 5, 2010

Post image for The best tools to fight inflation

Not that any of them are all that great.

The hot air balloon above is inflating. Get it? Get it?! Sorry. I’m tired.

There are only so many ways our government can eliminate the deficit and eventually pay off its gigantic debt. The least painful—and the one federal officials were desperately hoping for when they enacted the stimulus—is to grow the economy. With the economy growing, they get more tax revenues without having to change any laws.

Two, less optimum solutions are to raise taxes or spend less. Both of those make voters angry. Spending cuts sound good until you realize it means your kid’s classroom goes from 25 students to 30 students. Raising taxes never plays well, even when you purport to target the highest-income households.

That leaves inflation. No politician has to vote for it. It’s hard for rivals to point to interest rates and say, “Congressman Smith did this!” Inflation is simply the easiest way to pay off the deficit without alienating your constituents. Yeah, it’s weak, but when push comes to shove, you’ve got to believe inflation is going to rise before Congress successfully balances the budget.

So where does that leave you? And what can you do to make sure a devaluing dollar doesn’t decimate your portfolio? And for that matter, how can you stop Pop from excessive alliteration?

The myth of stocks as inflation-fighter.

One of the most common arguments in favor of investing in stocks is that they keep your portfolio from being silently eaten away by inflation. For your retirement money to keep its earning power, the yarn goes, you need assets whose returns will outpace inflation. Stocks are one, good answer.

Except they aren’t. In fact, stocks tend to do terrible when inflation is high. Take a look at this chart from Martin Capital Advisors.

In times of rapid inflation (the gray boxes), the S&P 500 (the green line) tended to drop, sometimes by a huge amount.

The point is, while stocks will probably outpace inflation over the long-term, holding stocks as a short-term panacea to what you might think is a coming bout of major inflation doesn’t make sense. Indeed, it seems misleading that the two issues ever got combined. Yes, inflation is an enemy to your portfolio. Yes, stocks—even at a conservative 5% growth rate—outpace the average inflation rate of about 3% over the longterm. But the two aren’t built to counteract each other.

What about commodities?

It would seem that commodities—such as oil, natural gas, and, I don’t know, timber—would be better inflation hedges. After all, if prices go up, the prices on the raw goods we need to make things should go up, too. The problem, of course, is that a ton of things, in addition to inflation expectations, influence commodities prices. Let’s take oil for example. This chart is from Inflation Data:

You’ll notice that the 1979 high for oil (in 2010 dollars) wasn’t topped again until 2008. Of course, inflation didn’t go down over that long time period. Quite the contrary. There were just a few hurricanes and a couple major oil crises that jostled the price of oil around, even as inflation made its inevitable climb upward.

Other commodities face similar circumstances. But even if they didn’t, keep in mind: Commodities reflect inflation expectations. So if you’re thinking about buying some oil ETFs right now in expectation of high inflation, you’re already late to the game. Even if inflation does rise rapidly, if it doesn’t keep up with the lofty inflation expectations the market has set for it, commodity prices could still drop.

And I’m tempted to skip gold, but what the hell…

Not that some reasonable people aren’t making arguments for gold investments. It’s just I feel like it’s unfair to keep beating up on this one. One last chart, also from Inflation Data:

Similar to the oil chart, you’ll see that even though the price of gold, currently at about $1,200 an ounce, has surged this year, it’s still nowhere close to the $2,251 peak it reached in 1980 in today’s dollars.

If anything, gold is a crisis hedge. If the U.S. government collapsed and the world collectively decided to revert to a medieval trading system in which precious metals of limited industrial use became the currency du jour, then gold might be a good investment. When I write about this, a common counterattack is to say that the dollar itself only has value by fiat (i.e., because the U.S. government says it does).

They’re absolutely correct, but that’s the whole point. The dollar has the fiat, both from the government and (implicitly) from investors who flock to it in the face of danger. Gold has an implicit fiat from a limited number of investors and practically no governments. And…oh forget it. If you’re going to buy gold, at least don’t listen to Glenn Beck and buy coins through Goldline.

TIPS: An imperfect option, but the closest to perfect you’ll get.

Treasury Inflation-Protected Securities are Treasury bonds created by the U.S. government whose principal also adjusts with the Consumer Price Index. As many people point out, CPI is an imperfect measure of inflation. Even putting aside the specious, government-lies-about-everything arguments for a moment, there is no possible way that what you spend money on will track CPI exactly. If you, for example, have to spend a lot of money on healthcare, whose cost is rising several times faster than CPI, your personal inflation rate will be higher.

However, TIPS, and their less-mentioned cousins, I Savings Bonds, will at least track inflation loosely, without the wild, speculative swings that stocks, commodities, and gold fall subject to.

Right now, a 10-year TIPS bond yields 1.09% after that periodic inflation adjustment. Given that regular Treasury bonds of that length yield less than 3% right now, that implies investors think inflation over the next decade will actually be extremely low.

And best of all, TIPS can easily be bought straight from the U.S. government. One word of warning though, if you buy them this way, make sure you hold them until they mature. Selling individual bonds is expensive, and bond prices will move around as interest rates move. If you think you’ll sell before the maturity date, try a TIPS mutual fund or ETF instead, though they won’t track inflation as exactly.

Anyway, I’m sure there are good arguments in favor of some of the traditional inflation “hedges” investors have used over the years, and throwing a few charts out there does not a Ph.D. dissertation make. How would you challenge some of the arguments I’ve laid out here?


{ 9 comments… read them below or add one }

Rob Bennett August 5, 2010 at 12:45 pm

I am not a fan of Buy-and-Hold. But I believe that a good number of the principles that were popularized under the Buy-and-Hold banner are pure gold. One of those principles is to “Stay the Course,” to not make adjustments to your investment strategies in response to short-term economic developments like an increase or decrease in inflation.

I just don’t worry about it. I believe that, if you try to jump in and out of things to cope with inflation, you are just going to make more mistakes. Stocks purchased at good prices do indeed offer good protection from inflation. If your real (above inflation) long-term return is 6.5 percent, you are going to be doing fine no matter what the inflation rate was at any one point in time. Getting 6.5 percent real on your overall portfolio is easy if you are willing to take valuations into account when setting your stock allocation.

I view it as short-term thinking to worry about the inflation rate that applies at any one point in time. Inflation comes and goes. What you want to do is to develop a strong long-term strategy and then stick with it.


Tim August 7, 2010 at 3:16 pm

“Given that regular Treasury bonds of that length yield less than 3% right now, that implies investors think inflation over the next decade will actually be extremely low.”

Pop, I’ve heard the same thing: that investors generally think inflation will continue to be low. At the beginning of the article you laid out the possibilities for eliminating the deficit and your belief that inflation will actually rise. I tend to agree with you, however usually I prefer to go with the investors. since they have skin in the game and know more than me. Do you know why investors seem to think inflation will continue to be low?

Pop August 7, 2010 at 6:55 pm

Hey Tim,

Thanks for your comment. It’s really hard to determine why investments are doing seemingly irrational things until long after the fact. And of course, maybe everyone is being rational and I’m the crazy one. At the height of the financial crisis, for example, the stock market was priced for a recession but the bond market was priced for a huge depression. Everyone was left scratching their heads as to why stock investors would react differently to the same events as bond investors. It wasn’t until months after the fact that people started realizing hedge funds were having to liquidate their bonds to meet margin calls and investor withdrawals. It was a great time to get deals on bonds, but everyone thought the bond market must have known something everyone else didn’t . That’s a long way of saying who knows? But just one example of what could be going on. Thanks for your comment.

K Smith August 8, 2010 at 7:03 pm

Pop, you didn’t answer Tim’s question. He asked why investors seem to think inflation will continue to be low. Your answer was, “Who knows?”

Tim, I can answer your question.

The retail investor got skewered in the market, has lost 1/3 of his or her home value, and is sitting on the investment sidelines. The only ones left in the investment game are the High Rollers, those with really big money – institutions, banks, pension funds, foundations. The High Rollers don’t just roll the dice and take their chances. They base their moves on the truth about the way the system works.

It is not true that, according to Pop, “inflation is the…easiest way to pay off the deficit without alienating your constituents.” The High Rollers know this. They know that the deficit can be paid off by issuing more debt.

In theory, the Treasury Department can keep buying new Treasury issues from itself to keep rates low indefinitely. This is what is happening now. This is what Treasury did during WWII so it could keep rates low so we could get cheap money to finance the war.

Banks are making a killing on this ’cause they can borrow money from the Fed at essentially 0% and earn 4% on Treasuries – a tidy return when the economy is projected to grow at only 2% per year for the foreseeable future. Why lend money and risk not get paid back when you can earn 4% with no risk? But I digress…

In peacetime, at some point enough people will catch on to the idea that you can’t pay off one credit card by transferring the debt to another one – this is essentially what the Treasury Department is doing. Bernie Madoff is a walk in the park compared to the system we operate under. It is just a giant Ponzi scheme, with our kids and grandkids left holding the bag. What we doing is the moral equivalent of child abuse.

When enough people realize what is going on, everybody will head for the exits, dumps dollars, and inflation will skyrocket. At that point, the dollars paid out at the maturity of the TIPs that Pop is encouraging all of us to buy will be worth so little that people will be using them for kindling.

Many of those who recognize the truth about where we are headed are becoming citizens of other nations. Three times as many Americans renounced their citizenship in 2009 as in 2008.

It is not true, according to Pop, that “(g)old has an implicit fiat from a limited number of investors and practically no governments.” Central banks were net buyers of gold in 2009. I am not speaking in favor of or against owning gold. I am just saying that central bank moves to buy gold indicate that there is fear of a weak dollar.

A recent U.N. report urges central banks to replace dollars with anything but a single currency or even multiple-national currencies. Two weeks ago a publication no less mainstream than CNNMoney ran the headline “Central Banks Join Gold Rush.”

In these times of “unusual uncertainty” as described by Mr. Bernanke, the Treasury Department will ensure that rates will stay low in the short run. But unless deceptive 1960s political and economic ideas are widely replaced with the truth about the way the system works in 2010, in the long run we are worse than dead. We leave our kids and grandkids impoverished and with a hell of a mess to clean up.

Inflation Alarmist April 8, 2011 at 9:24 pm

At this point, I’m feeling more uncertain and worried about future inflation than ever. It seems no one has an accurate reading on what’s about to happen – bears or bulls on the market. I could live feeling pretty secure with investing in some of these “tools” if there were more assurance the inflation will just keep creeping up year after year.

But I still can’t shake the fear that a period of accelerated inflation is approaching. Not that I expect the hyper-inflation of the bleakest predictions, though.

Tom Durham October 29, 2016 at 11:35 am

Inflation is a cancer for which there is no absolute cure. Gold and silver are as close as you can get to an antidote. At least in terms of something you can set and forget for the most part.

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