While inflation has been largely benign over the last several years it is unlikely to remain so forever, given the expansionary fiscal and monetary policies adopted by global central banks to combat the credit crisis that gripped the world’s economies in 2008.

As of this writing, 10-year treasuries were again approaching a yield of two percent, up from 1.5 percent just a few months ago.  In their daily lives, many investors have seen the prices for various goods and services continue to rise, providing anecdotal evidence that inflationary pressures continue to seep into the real world as well as the financial system.

In studying inflation over the last 100 years, we have seen that there is no single asset best suited to provide a hedge against inflation risk. Rather, we have found that a multi-asset approach is more likely to deliver the results desired by investors.

Are Traditional Investments Flawed?

There is a common perception that gold is a good hedge against inflation as it is a store of value and can retain its purchasing power in the event of rampant price increases.  This may have been true when currencies were actually backed by gold, but may be less true today.  Also, if everyone believes that gold is a good hedge, then its price will tend to rise as demand for gold rises with expected oncoming inflation.

We might also expect other commodities to be a hedge against inflation, since sometimes inflation is supply-side driven and as inputs to production rise, so do price levels.  The volatility of commodities as an asset class can be challenging, however, while the pricing of both oil and gold can be impacted by factors other than inflation (industrial demand, for example).

Short-term government bonds or short-term bank deposits might also serve as a good hedge. The argument is that this cash is given a fixed interest rate for a short period of time. The interest rate will have expected inflation built into it. To the extent that there is unexpected inflation, the rates will adjust for the next period of investment and since each period of investment is so small, the investor has a better chance of keeping up with both expected and unexpected inflation, though with a delay. [ETF Chart of the Day: Inflation Protection]

Treasury Inflation Protected Securities (TIPS) are thought to be good investments against inflation.  The underlying bonds promise a real return to investors.  Thus, if inflation is higher than expected, the bonds adjust their interest payments to keep the investor’s real return at the expected level. There are issues with TIPS, however, including the timing of interest payments and the fact that both principal and interest are subject to federal taxation in the year in which they are generated.  Again, TIPS as a stand-alone inflation hedge would appear to be flawed.

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