Back in 2004, I wrote “Deflation: What Happens When Prices Fall.” I argued that the U.S. had shifted from an economic environment where inflation (rising overall price level) was the normal underlying price trend to one where deflation (falling overall price level) would dominate. Judged by book sales, I didn’t convince too many people.
Still, the basic argument has held up reasonably well in recent years. Deflationary information technologies and digital commerce are growing in economic significance. Deflationary pressures have become more commonplace in many parts of the world.
That said, what if the current backlash against globalization, higher wages in China, the embrace of easy money policies by central bankers and other factors eventually conspire to push prices higher for the next couple of years? What is the best way for long-term savers to hedge against the risk of inflation eroding the purchasing power of hard-earned savings?
Even moderate rates of inflation eat away at purchasing power. Let’s say a 50-year-old deposits $5,000 in an IRA in 2016. The account earns 1 percent annual interest rate while inflation runs at 2 percent. If she retires at age 65 — in 15 years — the future value of her $5,000 investment adjusted for inflation is $4,316. At 3 percent inflation, it’s $3,728.
There are two principal investment options available for savers setting aside money into a 401(k), IRA and the like to hedge against inflation. Stocks are an excellent inflation hedge for anyone with a longer term time horizon, say, five years or more. Yes, equity values typically fall when inflation gathers momentum but value is eventually restored.
Aside from stocks, a terrific fixed income investment to protect against inflation for individuals are U.S. government I-bonds. These savings bonds are designed to hedge against inflation, measured by the consumer price index. You buy them online at Treasurydirect.gov. You won’t pay a commission. The investment compounds tax sheltered until redeemed. I-bonds are simple, creditworthy and low-cost.
A more complicated alternative is Treasury Inflation Protected Securities, better known as TIPS. These CPI-indexed bonds come in 5, 10 and 30 year maturities. A drawback to TIPS for long-term savers is you can’t buy the securities directly from the U.S. Treasury in an IRA. You’ll have to go through a financial institution. That’s why most individuals own TIPS in retirement accounts through mutual funds and exchange traded funds.
Chris Farrell is senior economics contributor, “Marketplace,” commentator, Minnesota Public Radio.