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.

7 Comments

  • By Neil, June 15, 2012 @ 2:24 pm

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

    I was under the impression that the ’70s were sufficiently unusual in this regard that it got a special name (stagflation), and that inflation has historically been mostly a disease of boom times. Within my own lifetime, the only time inflation has been particularly noticeable was during the 2004-2008 energy boom, when it was averaging a little over 5% locally.

  • By Philip Brewer, June 18, 2012 @ 8:59 pm

    Hey, thanks for taking a serious look at my article!

    Let me just make one point on cash—it’s what debts and contracts are denominated in. In the short term, almost everyone owes fixed dollar amounts (for rent or mortgage payments, other debts, utilities, etc.).

    If you hold cash equal to, for example, 12 times your monthly rent, your inflation exposure is perfectly hedged. Whatever happens to value of the dollar, you know that cash will cover those rent payments. Any interest you earn in the meantime is yours to keep.

    Given that, I think cash holdings up to as much as a year’s total spending are perfectly reasonable.

    Again, thanks for your thoughtful post!

  • By Istan, June 19, 2012 @ 1:56 am

    Great to see you back, Frank! Really missed this blog.

  • By Craig, June 19, 2012 @ 4:25 pm

    Generally, a pretty good article with a pretty good response. Frank, I agree completely on real estate, and I think this was a real miss in the original article–I’d much rather buy real estate than gold at current prices. And the very best hedge against inflation is fixed-rate debt. I have some TIPS in my portfolio, but I’m may get out of them now that I have two (mortgaged) rental properties as inflation hedges.

  • By Frank Curmudgeon, June 19, 2012 @ 5:06 pm

    Neil:

    For a time post-WWII it seemed possible to goose the money supply and create a short-term boom followed by inflation, thus the association of the two. In the 1970s, for controversial reasons, economies started skipping the boom bit and just getting inflation without growth, thus stagflation. I think that generally if you look at the 20th Century, most instances of inflation in most countries were not economically happy times.

    Philip Brewer:

    Don’t sound so surprised to be taken seriously. People often take me seriously, after all, and if I can get taken seriously….

    I agree that if you have a series of known fixed payments to make in the future, such as rent on a lease, then holding cash against those liabilities is a good hedge. However, 1) it is actually a hedge against deflation, since your liabilities are essentially a bet on inflation and 2) most of the expenses you will face are not fixed and will go up in nominal terms with inflation.

    Istan:

    Good to be here.

  • By Barinr, August 9, 2012 @ 7:05 pm

    What if I told you that the stock market would drop 90% and inflation would rise to 100% within 12 months, what would you suggest? Some very smart people think this will happen.

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