How to hedge your nest egg against inflation

Q I consider myself to be a successful student of the Chris Farrell School of Money Management. We have weathered the economic storm by living below our means and maintaining an emergency fund, big-ticket-item savings account, retirement accounts and one for monthly and semi-annual outlays. As my wife and I approach retirement (I'm 59 and she is 58) our big concern is hyper-inflation brought on by federal and state governments' inability to budget and plan long-term. We use the bond/equity ratio based on age for asset balancing. Our funds are mostly in broad-based index funds with no gold or gold index funds. Help!

PAUL

AYour investment strategy is sound. Don't panic.

I don't buy the scenario that the U.S. price level is poised to follow Weimar Germany or Zimbabwe into hyperinflation. A more realistic concern is double-digit U.S inflation rates of the late 1970s and early 1980s. The Consumer Price inflation peaked at 13.5 percent in 1980, and hammered the stock and bond markets. I'm skeptical of that scenario, too. Central bankers are haunted by those years. They don't want that genie out of the bottle. Competition for markets and profits also puts a lid on inflation.

That said, a big risk for savers is that even modest inflation erodes the value of their money. Rates in the 1 percent to 3 percent range sharply reduce the purchasing power of savings. Consumer price inflation over the past 12 months is running at 3.6 percent. The core rate -- the CPI minus volatile food and energy -- over the same time period was 1.5 percent. Many economists reasonably fear brief inflation of 5 percent to 7 percent following the extraordinary actions the Federal Reserve took to bail out the banking system and avoid a depression. So it pays to hedge a portfolio against inflation.

What are some hedges? Good stocks with plenty of cash flow typically get hammered when inflation rears, but only short term. Blue chip corporate earnings tend to keep pace with inflation since these companies have some pricing power. Treasury bills do an excellent job of keeping pace with inflation. The price for that inflation hedge is no growth or earnings premium over inflation. You can get a bit more growth from Treasury Inflation Protected Securities (TIPS) and Series I savings bonds. Gold, a traditional hedge, is expensive, up about 140 percent from 5 years ago. A better commodity play is investing in a broad-based well-diversified commodity index fund or exchange-traded fund that includes gold.

The way you described your finances suggests you are in fine shape for good times and bad.

Chris Farrell is economics editor for "Marketplace Money." Send your questions to cfarrell@mpr.org.

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