Farrell: Your time horizon is critical in a strategy to hedge inflation

Q: What is your view on the never-before-experienced impact of so many global central banks pouring new money into the economy to keep rates low with the prayer of priming the growth pump? As a leading-edge boomer, I am forever leery about inflation. Perhaps it was that 11¾ percent mortgage I had years ago. Anyway, my educators left me convinced that printing money is a delicate thing, so I keep feeling like there is this other very large shoe out there, waiting to drop. What’s concerning is what might happen to those of us under the shoe. What was/apparently still is conceived as priming seems a lot to me like aiding and abetting medium-term performance across the developed world. Your thoughts?

Stoddard

A: The timing of your question is spot-on, with many Wall Street economists busy hiking growth forecasts and shortening the time frame for when interest rates might start climbing. The Fed’s latest policymaking meeting had the central bank winding up its massive bond-buying program, or quantitative easing, in October. Assuming the job market continues to improve, the chatter on Wall Street about higher rates and signs of incipient inflation will intensify in coming months.

I remain in the high-inflation-skeptic camp. I expect the annual inflation numbers will be relatively muted, nothing near the experience of the 1970s. The combination of a competitive global economy, the deflationary impact of information technologies and a united front among central banks against inflation is a force for moderate price increases.

That said, even if I’m right and inflation stays modest after adjusting for brief price spikes, moderate rates of inflation still erode purchasing power. For example, if you put $1,000 into an IRA this year, the investment would be worth a fraction above $600 in a quarter-century if inflation averages a modest 2 percent. That assumes no interest payments to offset inflation.

So, what’s the best way to hedge against the risk of higher inflation? Your time horizon is critical to the answer. For instance, when inflation has surged in the post-World War II period, the best- and worst-performing investments have been commodities and bonds, respectively, over the following 12 to 18 months. That’s according to Alexander Attie and Shaun Roache, economists at the International Monetary Fund. Yet in their 2009 paper “Inflation Hedging for Long-Term Investors,” they noted that, once past that short-term period, bond returns start outperforming inflation thanks to higher yields and more stable prices. Meanwhile, commodities start to decline in value.

A similar dynamic holds with equities. Stock values typically fall when inflation rears. However, stocks do well relative to inflation over a time horizon of five years or more.

Cash, typically U.S. Treasury bills, is a partial inflation hedge. The real advantage of cash is its simplicity and low cost, plus the money is there when inflation abates and new investment opportunities open up.

Treasury Inflation Protected Securities, better known as TIPS, and the I-bond are default-free securities designed to protect long-term savings from inflation. I’m a fan of TIPS and I-bonds. The higher the inflation rate ends up, the more valuable they are.

Chris Farrell is economics editor for “Marketplace Money.” His e-mail is cfarrell@mpr.org.

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