Until just a little while ago a fear of deflation was all the rage. In-the-know types nodded their heads gravely and showed erudition by expressing a fear of something that hasn’t been a problem in this country for 75 years. And they were right to fear it. Deflation is a really nasty thing. More than anything else, it is what made the Great Depression great. But as it happens, our guy at the monetary controls, Ben Bernanke, is a particular expert on deflation and the Great Depression. He may or may not succeed in steering our economic ship clear of the shoals, but deflation is one particular rock he is sure not to hit.
Prices did decline in the fourth quarter of 2008, down –3.3% as measured by the Consumer Price Index. Annualized out, that’s a very scary –12.4%. But, knock on wood, that was a brief episode that is now over. The Fed has been working furiously to pump as much money into the economy as possible, doing everything short of handing out bags of the stuff on street corners. Prices were up in both January and February, totaling +0.7%, which is a +4.3% annual rate.
So the Informed Consensus Fear has shifted from being focused on deflation to an uncertain fear of both deflation and inflation. Personally, I predict inflation. Maybe not in 2009, but in 2010 and beyond.
What does this mean to you, the ordinary consumer? Good question. Last week Flexo at Consumerism Commentary had a rather redundantly titled post How to Prepare for Inflation and Higher Prices on that very subject. It suggested that the reader make investments that would fare well under inflation, such as gold and inflation-protected Treasury bonds. That’s not unreasonable, but like much personal finance advice, it dangerously assumes facts about the reader’s situation.
Before deciding to take significant action to hedge against the possibility of inflation, a person should first consider what the impact of a bout of inflation might actually be on their particular situation. Although inflation is, on balance, a bad thing for the economy, it does not follow that it is necessarily a bad thing for every individual person’s finances.
Inflation, at its most basic, is a decrease in the value of dollars relative to everything else. That means that assets and debts denominated in dollars, e.g. cash, loans, bonds, and the like, also decrease in value relative to all the many assets that are not defined in terms of dollars, e.g. stocks, commodities, and real estate. Although rarely discussed in the personal finance world, in the medium and long term this is the most significant effect of inflation.
If you own things denominated in dollars, those assets will lose value under inflation. That’s a big problem if you have cash in a sock drawer or a portfolio of Treasury bonds. However, the other side of the coin is that debts you owe also shrink because of inflation. If you have more debt than you have dollar denominated investments, then not only do you probably have no need for an inflation hedge, but you should be cheering inflation on.
To be sure, not all dollar assets and debts are equally diminished by inflation. On the asset side, cash and long term bonds would suffer the most, while money market funds, which can adjust interest rates upwards, would shrink less. For debts, the biggest shrinker would be a 30 year fixed mortgage, while credit card debt, which carries a variable interest rate, would give up ground less slowly.
If asked to concoct a scheme to profit from inflation, a sneaky financial engineer such as myself might suggest borrowing a substantial sum, ideally at a long term fixed rate, and using the proceeds to buy a real asset. If yours is one of the many households that owns a house with a big mortgage, you have already carried out this clever maneuver. Particularly if you have a fixed rate mortgage, inflation is already your best friend. Adding on further inflation hedges, by taking on investments that would do well under inflation, increases the risk of loss if inflation fails to materialize, or if, heaven forbid, we wind up with deflation after all.
If, on the other hand, you are a renter that does not owe very much and has dollar assets like cash and fixed income investments, inflation would not be kind to you. You should consider moving out of those dollar assets and into non-dollar assets. Inflation protected bonds, such as the TIPS issued by the US Government, are an attractive option as a substitute for normal bonds. TIPS are, essentially, bonds denominated in real dollars. The bond’s principal is reset periodically with increases in the CPI so that it never loses ground to inflation.
Gold is often mentioned as an inflation-proof investment. It is a poor one. The value of gold does, in a general sense, go up with inflation, but then so do almost all other non-dollar investments. And gold fluctuates in price, sometimes dramatically, for its own reasons. It is a sort of doomsday investment, increasing in value as the general level of fear increases and decreasing as calm returns. I think we are at a higher than typical level of fear now, so gold will probably tend to go down in the future as calm gradually takes over.
The obvious alternative to fixed income is, of course, equity, i.e., stocks. If you already have enough stocks in your life, you might consider real estate or any other non-dollar investment. (Forbes article with some exotic ideas I don’t particularly recommend here.)
Inflation has the effect of transferring wealth from people who are owed money (creditors) to people who owe money (debtors.) Under deflation the transfer goes the other way. Depending on which side of the ledger you fall, you may be already all set for a nice round of inflation.