How to Beat Inflation

Wise Bread just ran a post on How to Understand and Protect Yourself From Inflation. I often think pieces on inflation are obvious. But perhaps I am just showing my age.

Since 1984 (when I graduated high school) inflation has averaged about 2.9%. And it has been pretty stable, falling outside the 1.1% to 4.6% range onlyChicklet-currency twice. (0.1% in 2008 and 6.1% in 1990.) That is almost 30 years of smooth sailing, a period when inflation was an easily ignored background hum.

Indeed, inflation of 3% is not something you usually notice directly. Prices for things change all the time, some up, and even some down. Only when the government totals it all up do we find out prices were up 3% on average.

We oldsters (I am including Philip Brewer, the author of the Wise Bread post, who in his picture appears to be another mid-lifer) remember the era before the calm. In the 12 years 1969-1980, inflation averaged 7.7%. And it was unstable, ranging from a low of 3.3% in 1971 to a high of 13.3% in 1979. In 1972 it was 3.4%. Just two years later, in 1974, it clocked 12.4%. In just the four years 1977 to 1980, inflation totaled 48.2%.

In those bad old days you did not need government numbers to notice inflation. It was all around you. And it was not that a few things got more expensive. Everything did. Because, and I think this was pretty obvious at the time even to us kids, the dollar was losing value.

Dollars becoming worth less is probably the best way to think about inflation. Because the fundamental inflation beating strategy is to avoid owning those shrinking dollars and to avoid being owed them.

Brewer offers four ways to protect your savings from inflation. I will review them in descending order of plausibility.

Inflation Indexed Bonds

The US Treasury issues what are called TIPS, the pet project of a Goldman banker who lived through the bad inflation years and then became Clinton’s Secretary of the Treasury. In addition to paying interest, the face value of these bonds increases with inflation. So if you buy one for $1000, and inflation goes up by 50% over the ten years it takes for the bond to mature, you will get $1500 when you hand it back in.

This is the most direct form of inflation-protecting your savings and easily the one with the smallest possibility of error. At the end of the bond’s term you will get your original principal amount, adjusted for inflation, guaranteed. But that level of precision comes at a steep cost. The current interest rates on these bonds are approximately zero, and occasionally negative. So you get the real value of your money back, and essentially nothing else.

Gold

This is the most traditional of inflation hedges. Brewer tells us that “Over the centuries, gold has held its value like nothing else. Over the decades, though, gold is sometimes pretty crappy.” Which pretty much sums up its shortcomings.

Gold is a thing that is not a dollar, so it satisfies the core principle of protecting against inflation. But as things go, it is not particularly useful to own. Other than being able someday to sell it, owning it does not give you anything. So it is just like the TIPS, except without the laser-like inflation matching accuracy. Gold will only approximately hold its value in real terms.

The same could be said about such things as fine art and classic cars, that they will approximately hold their value after inflation. But at least you can look at the art and impress your friends with the car in your garage.

Equities

A stock is a share in the ownership of a company, and companies own many things that are not dollars. So this ought to qualify as a great inflation hedge.

During a period of inflation, companies will face rising costs for the things they buy and the wages they pay their workers — but they’ll generally be able raise the price of the things they sell by a similar amount.

The result is that investing in stocks during an inflation isn’t too different from investing in stocks any other time. You want a diversified portfolio. You want your money invested in companies with good management in a profitable business. If you do that, the inflation thing will sort itself out.

To see the flaw in this reasoning, you only have to look at the stock market performance from 1969 to 1979. The S&P was up an average of 4.4% a year over that period, while inflation averaged 7.3%. Yes, owners of equities also got dividends, but on January 1, 1980 the principal invested was worth only 74% of the real value it had on January 1, 1969.

The problem is that times of high inflation are usually also bad economic times. And those are bad times to own stocks.

Cash

I find it hard to believe that Brewer listed this as one of his top 4. He is talking about money market funds, rather than money stuffed in a mattress, but still.

Money funds, essentially pools of very short term bonds, are certainly greatly preferable to longer term bonds in times of inflation. But they are still made up of dollars.

Relying on the rates paid by the money market to track inflation is problematic. First, because historically those rates have lagged inflation, both in the sense of falling a bit short and in the sense of reflecting the recent past better than current events. Second, money rates are more or less set by the Federal Reserve, and while the Fed may tend to raise rates (that is, contract the money supply) to counteract inflation, that is at best a general tendency rather than a rule.

There is another asset class that comes immediately to my mind when I think about preparing for inflation. It was quite successful in the 1970s. It is a surprise that another person who, I assume, can remember disco and mood rings did not remember it.

I am talking about real estate, particularly the houses that we live in. As non-dollar objects go, a house has a lot to say for itself. It is relatively cheap to buy and sell, as compared to, for example, collectibles. It has historically held its value against inflation quite well and, in most locations, will always be a thing of intrinsic value, as compared to, for example, gold. And you get to live in it while it wards off the inflation demons.

Even better, you can finance a house on very attractive terms. You can usually borrow 80% of the purchase price at rates that are as low as a consumer is ever likely to find, even before the favorable tax treatment is considered.

And that mortgage is itself a powerful inflation fighter. Just as being owed money is a bad thing under inflation, owing it to others is a great idea. Over time, the value of your debt will naturally shrink in real terms. Put another way, the dollar value of the house will go up with inflation, but the size of the mortgage will not. That is bad for the bank, but awfully good for you.

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