What to do about the coming inflation (if it comes)?

[heyyou]

A with a C attitude. Broad diversification including some of each of the inflation buffers then not worry too much about what I can't control. We will muddle through somehow. Maybe we will have to move somewhere cheaper someday, or travel less, or work at minimum wage jobs in late retirement. We will hit those points long after most of the rest of the population does. Neither the good times nor the bad times last forever.

To paraphrase Churchill, TIPS are not a good inflation hedge, but they are better than all of the other ways that have been tried. If the TIPS buyers don't trust the CPI-U numbers, that should eventually be priced into the rate.

Read an article years ago that named different causes of inflation, each with a different hedge as mentioned by other posters above. Energy price shocks are different inflation than gov't monetary policies, etc. One other hedge was just having a little more equities but I can't remember what specific circumstances that helped, maybe it was from having fewer bonds.

When rates are high again, think about how long term zero coupon bonds will vary in price. In the early 80s when my annual income was $30K, I skipped buying newly issued 14% zero coupon bonds because I was intimidated by eventually facing $60K a year of phantom income from the lot. Think what those bonds would be worth if they were throwing that much phantom income. Look at the big picture, not just the negatives as I did then. High inflation may offer you the opportunity of long term, guaranteed double digit bond income from your shrunken portfolio, if you will buy bonds when no one else likes them due to recency.

[semtex]

max out my mortgage and no prepay one cent

[Gone4Good]

Quote:

Originally Posted by semtex max out my mortgage and no prepay one cent

But then the question is . . . what do you do with the money that would have gone to repay the mortgage? Are you any better off with a mortgage if your larger portfolio doesn't keep pace with inflation, or cover it's carrying cost?

[Gone4Good]

Quote:

Originally Posted by audreyh1 The high inflation of the 1970s was driven mostly by wage inflation which is non-existent today due to globalization.

I'll take this one further . . . NONE of the pre-conditions that caused stagflation in the 70's are present today. Low growth and high inflation were caused by supply shocks that lowered the country's non-inflationary growth rate (oil embargo, 70% marginal tax rates, wage & price controls, etc.). These things caused the country's supply curve to steepen and move to the left, resulting in both higher unemployment and higher inflation. Meanwhile, monetary stimulus pushed the demand curve to the right, which caused prices to increase further. But higher prices couldn't induce much of a supply response because of the the myriad of structure impediments to growth. So prices rise and unemployment stays high. Stagflation.

The current situation bears no resemblance to the 70's. What we're dealing with today is a demand shock, much like the 1930's. For too long aggregate demand was artificially inflated by cheap credit. Aggregate supply rose to meet that demand. Now a credit crunch and excess leverage has caused aggregate demand to fall precipitously. But productive capacity is still mostly geared to meet the peak demand of the credit boom. (i.e. the demand curve shifts to the left and the supply curve remains unchanged causing lower prices and lower output). In this environment, easy money can help increase aggregate demand without fear of causing inflation.

[semtex]

I agree, that's the key, whether i could beat 4.875%(my mortgage rate). As a DYI play, so far so good.

[Gone4Good]

Another thought expanding on these comments . . .

Inflation is said to be "too many dollars chasing too few goods." "Too many dollars" obviously refers to accommodative monetary policy whereas "too few goods" means an economy's ability to produce products and services . . . it's "supply side". As long as the supply side grows in proportion to the monetary base, there is no inflation.

What has happened over the past few decades is that places like China and India have unshackled the productive capacity of their economies. But instead of turning that capacity inward in an attempt to meet, and stimulate, domestic demand, they've turned it outward to meet world demand. This has had an enormously deflationary effect on global goods and services. And because central banks focus on the price for goods and services, they've been able to keep monetary growth higher than it otherwise would be.

But something happened on the way to Nirvana. While the global supply of goods helped to prevent normal price inflation, the excess liquidity seems to be causing asset price inflation. Central banks never considered asset bubbles to be within their purview, but that thinking is starting to change in the wake of two giant bubbles in the last decade.

So this period may be somewhat different from either the 30's or the 70's. Instead of being faced with a choice between consumer price inflation or consumer price deflation. The choice going forward may be between consumer price deflation and asset price inflation.

[Meadbh]

Quote:

Originally Posted by smjsl @Meadbh: sorry for missing orientation, but what do "Au, Ag, RRBs" stand for?

Au = Gold
Ag = Silver
For reference, see the Periodic Table of the Elements:
http://go.hrw.com/resources/go_sc/periodic/SSHK1PER.PDF

RRBs = Real Return Bonds
Real Return Bonds
(I live in Canuckistan).

[samclem]

Quote:

Originally Posted by . . . Yrs to Go But something happened on the way to Nirvana. While the global supply of goods helped to prevent normal price inflation, the excess liquidity seems to be causing asset price inflation. . . So this period may be somewhat different from either the 30's or the 70's. Instead of being faced with a choice between consumer price inflation or consumer price deflation. The choice going forward may be between consumer price deflation and asset price inflation.

An interesting observation. At first glance, I don't think I'm as much bothered by asset price inflation. My holdings get artificially inflated, if I rebalance now and again and I sell high (the most inflated categories) and buy low (the lagging categories) maybe I even benefit over the long haul. But, with consumer price inflation, I'm always on the buying side, so higher prices always hurt.

In fact, as a holder of assets, if asset inflation over the long term matches consumer price inflation, I'll be fine.

Quote:

NONE of the pre-conditions that caused stagflation in the 70's are present today.

Mostly I agree, but I don't think we need a repeat of the '70s to have a repeat of high inflation. My impression is that historically (around the world) most inflation has been caused by governments expanding the supply of currency well beyond the ability of the supply side to produce gods and services of commensurate value. I see the same factors shaping up now--a government eager to pump more money into the economy with another "stimulus," (what will it take to finally discredit Keynes?). With a huge debt to pay in the coming decades, there will be a lot of incentive to keep the presses going. Paying back the Chinese and others with deflated currency may look like the least-bad solution as our fiscal woes mount.

[Gumby]

This is one of the best discussions we've had on here recently. Kudos to everyone who is participating, with a special shout out to smjsl for jumping right into the fray with an excellent first post.

[REWahoo]

Quote:

Originally Posted by samclem My impression is that historically (around the world) most inflation has been caused by governments expanding the supply of currency well beyond the ability of the supply side to produce gods and services of commensurate value.

An interesting theological twist to economic theory. Might have some real merit.

[samclem]

Quote:

Originally Posted by REWahoo An interesting theological twist to economic theory. Might have some real merit.

Unintended, but I'm going to have to ride it all the way now. I wonder if an expanded M2 will lead to deity inflation?

On second thought, I'll let it go now.

[Bestwifeever]

Quote:

Originally Posted by Gumby This is one of the best discussions we've had on here recently. Kudos to everyone who is participating, with a special shout out to smjsl for jumping right into the fray with an excellent first post.

I was just thinking that, Gumby. And I was also thinking, dang but these people are all so smart and have such good underlying points to make, wherever they stand on how to deal with potential inflation. This board is so educational!

[charlie]

I loaded up on CDIPs about 3 years ago. These are inflation linked
corporates (and one big CD) that pay year-over year CPI plus 2-4%.
I was patting myself on the back until CPI went negative. These
are intermediate term notes maturing in the next 4-6 years. Even
though they are suckey now, I think the sun will shine again by 2011.

I also like Templeton Global Income (GIM). It is a fund that invests
in international soverign debt. It pays a monthly dividend, currently
about 5.4% annual, with a big December bonus normally. This fund
has beaten the c**p out of Vanguard's Wellington the past 20 years
and I like and own Wellington as well. Don't bet the ranch, however.

I have been raising my stake in International Explorer. This
fund invests in small cap international stocks. Again, don't bet the
ranch.

Finally, I AM betting the ranch (in my IRA) on Wellesley Income.

All the above are in my IRA.

My after tax money is in Managed Payout Growth and Distribution, with distributions reinvested until the return of capital component settles down. This fund is the most diversified of all of Vanguard's balanced funds. It is a 70/30 stock to equity with 30% of the equity being international. Included in the 70% equity is 5% REIT. The bond component includes some TIPS. This fund is slightly ahead of Wellington
YTD.

Keep in mind that I am 75 and investing for inflation "protected" income
and capital preservation. My wife starts RMD in 2011 and I am thinking
about converting her IRA to an Immediate Annuity at that time if interest
rates are favorable.

Cheers,

charlie

[MichaelB]

Another voice here not convinced inflation is the threat we should fear the most. Just a couple of random thoughts:

High, chronic inflation is difficult without wage inflation, and in the US real wages declined over a decade that saw immense credit growth. The recent increase in real wages was via deflating CPI, not wage increase.

Net credit is declining even as the Fed floods the world with US$.

Consumer credit capability is impaired and will not improve as long as so many homeowners (more than 15%?) have outstanding mortgages that exceed total market values for their homes.

Between 2003-2007 we saw 3X increases in commodity prices, 2X increases in residential housing and an breathtaking increase in consumer credit, yet inflation averaged around 3%.

We may see something new – continued deflationary pressures combined with rising tax rates.

[Gone4Good]

Quote:

Originally Posted by samclem Mostly I agree, but I don't think we need a repeat of the '70s to have a repeat of high inflation. My impression is that historically (around the world) most inflation has been caused by governments expanding the supply of currency well beyond the ability of the supply side to produce goods and services of commensurate value.

True. But you do have to assume a bunch of stuff that hasn't happened yet. Chiefly that the Fed will keep printing money even after supply & demand comes back in to balance. While you cite some reasons they may, there are also plenty of reasons that they won't. I happen to think economists today know a lot more about monetary policy than they did in the 70's. I wouldn't count on them making the same mistakes.

I take some comfort in the hawkish statements of some Fed governors recently; indicating that interest rates may need to move upward as aggressively as they've moved downward and that they may need to tighten monetary policy even when unemployment is high.

We won't know for several years, of course. But if I had to place a bet today, I would put my money with the majority of mainstream economists who are forecasting benign inflation and not with the gaggle of internet and TV commentators forecasting hyper inflation.

[antmary]

Hi Y'All
It's been awhile since I visited...here's the story:

We are finishing up building a small 3/2 house on 10 acres with a good well, ditch water for irrigation, and close to a small town. We have been planning this for years (not tin-foil hat thinking, either, but diversifying in as many areas as possible). We built it ourselves, and paid as we went.

Re investments:
non-taxable (Roth IRAs) - 35% TIPS and Intermediate Treasuries all through Vanguard.
Taxable - 37% stocks (Vanguard) 60/40 TSM/FTSE All World ex US
Gold - 5%
Cash (CD's) 23%

We are seriously think about re-balancing vis a vis Harry Browne's Permanent Portfolio:
25% Cash in Treasury Money Market fund
25% Stocks - 60/40 US/International
25% Bonds (US Treasury)
25% Gold - coins
When one sector tanks, then another will hold up the boat.

We love this country, and plan to stay.
antmary

[ejman]

Quote:

Originally Posted by . . . Yrs to Go True. But you do have to assume a bunch of stuff that hasn't happened yet. Chiefly that the Fed will keep printing money even after supply & demand comes back in to balance. While you cite some reasons they may, there are also plenty of reasons that they won't. I happen to think economists today know a lot more about monetary policy than they did in the 70's. I wouldn't count on them making the same mistakes. I take some comfort in the hawkish statements of some Fed governors recently; indicating that interest rates may need to move upward as aggressively as they've moved downward and that they may need to tighten monetary policy even when unemployment is high. We won't know for several years, of course. But if I had to place a bet today, I would put my money with the majority of mainstream economists who are forecasting benign inflation and not with the gaggle of internet and TV commentators forecasting hyper inflation.

It would certainly appear that the long term bond markets are in agreement with your assessment. If there was one lesson from the 70's is the pervasive destructiveness of high inflation. Paul Volker showed that this could be controlled (albeit with substantial short term pain). I see no reason the same approach wouldn't work again if needed particularly since a similar minded economic team (heck even Paul is hanging around in there) seems to be in charge.

[smjsl]

@FIREdreamer: PIMCO's Commodity Real Return Fund for fighting inflation sounds interesting but active management scares me (although I plan to post on that subject separately)

@Meadbh: Thanks for the explanations. It's been a while since I had to take chemistry :-) Have you considered I-bonds instead of or in addition to RRBs? Or are you ineligible for some reason for I-bonds or are there RRB advantages (e.g. I would be wondering how I-bonds are taxed with dual citizenship)?

@samclem: Thank you for interesting article. Some thoughts on it:
- I did not quite get why backwardation is considered as a source of extra income, while contango is not mentioned at all. I would expect contango during high inflation times but maybe they are implying that backwardation is normal in not-so-high inflation environment? Did not seem convincing.
- Interesting points on REITs (both yours and article's) - I guess it needs to be moved down in the list.
- I agree with you that stocks have done well in low-inflation environment. However, I am more concerned about high inflation environment (again, even if not now, maybe in 10-20 years for some new reasons). Article points out stocks on average outperforming inflation in the past but with major volatility. And, well, that's the past... (separate post might be coming on this subject)
- Regarding TIPS, there is nothing new (they did mention how taxes may reduce the earnings)
- Article says how treasuries had "5.5% annual return, edging out inflation at 4.1%. That's before taxes." Well, that means they will lose on after-tax basis.
- I keep coming back to why are CDs not considered in such an article? Would not they be better than treasuries or should they not at least be compared? In the past they have seemed to provide higher yields (from my own observations at least)

One more general comment on how I currently plan to approach retirement. What would be ideal for me is to have a guaranteed match for after-tax inflation, not an "average" match via stocks/reits/commodities/other highly variable vehicles. If I can accumulate enough $$ for say 60 (years) x[minimal survival level] (e.g. 1.2M for 20k min expenses), then I would use such inflation protection and would not have to ever worry about deflation, recession, boom or inflation (i.e. all 4 "seasons" by Harry Browne). Inflation would really be the only one that would need protection under such plan. Anything over the minimal-survival level would go into stocks and other "gravy". So, I think I might be stuck with CD/SPIA/I-bond/Treasury kind of approaches for this core sum.

As samclem observed, perhaps it's a form of high-cost insurance.

P.S. Appreciate the shout outs!

[traineeinvestor]

Inflation is a major issue for retirees looking at more than a short term horizon. Even 2% pa inflation can kill a retirement plan which does not address this issue given enough time. Historically, just about all asset classes have a patchy history of matching or beating inflation (including the much touted gold which underperformed inflation for a quarter of a century following its previous high).

Short term high levels of inflation/rising inflation also require different strategies than longer periods of low inflation - it seems to me that strategies that work well in one scenario may not work as well in others.

Like OP I am looking at 40-50 years in retirement and have heavily weighted my investments to (i) real estate and (ii) equities - in effect assets that have at least the potential to grow over time. I have to recognise that if inflation starts rising and interest rates follow, then the value of these assets may decline in the short term. For this reason it is (IMHO) important to have enough money to cover at least two years expenses in cash or short term funds.

I have relatively little in bonds and relatively little in commodities. There are no TIPS type instruments available here and overseas investments usually raise tax issues that outweigh the benefits of the investment .

If I was either living in the US or had sufficient knowledge of that market, right now I would be looking for direct investment in real estate (depressed prices) and locking in 30 year mortgages at today's current low rates expecting the rise in the value of the asset and its rent to combine with the fall in the real value of the mortgage to protect myself against long term inflation. (I only wish I could get fixed rates in Hong Kong .) Needless to say, I would adjust gearing to ensure a positive cash flow.

I'm looking into timber and farm land, but not having much success in finding something suitable.

[samclem]

Apologies in advance for another long-ish post.

Thanks to all who have chimed in so far. The discussion has been very useful for me.
Here's what I've learned so far:
1) There's no magic bullet out there--no investment that will keep up with inflation regardless of its genesis and effects and which will also produce market-matching returns if inflation remains at bay. Buying protection from inflation is like purchasing insurance, and you have to give up something else to get it. I feel after this discussion that we' haven't missed any big factors or possible solutions--that's valuable, thanks.
2) The belief that high inflation is coming is not unanimous. There are smart people here making informed arguments supporting the idea that the big inflation monster might not come at all. This has somewhat reduced my willingness to pay for a lot of inflation protection. And, for those (like me) who have less faith in the Fed's ability and willingness to get inflation in check once it starts, the existence of these alternative viewpoints explains why assets that offer some protection from inflation haven't yet been bid up and out of sight. But, that might not last forever--so if you need the "insurance," know that the premiums could escalate quickly.
And . . . audrey1, YearstoGo, FIREdreamer, MichaelB, ejman: I want you guys to be right. Inflation is a bad beasty, especially for us ants (the grasshoppers are less affected). If you are wrong, I hope I (and FinanceDude) are big enough not to say "I told you so."

What I'm going to do: Option C, but that's because of my particular situation. I have a COLA'd pension that covers our basic needs. In addition, 10% of our portfolio is I-Bonds I happened to buy when they were a great deal (approx 3.5% real return. I wish I could buy more at that rate. We won't see those days again unless a raging bull stock market returns and inflation fears are very low). But, I am going to buy a small bit of additional energy exposure (via VGENX)-just 2% of our total portfolio. Without this, only approx 8% of our equities were in the energy sector, with this addition we'll go to approx 11%. The S&P 500 stands at 12% in energy stocks. So, I can tell myself I'm NOT making a sector bet, I'm just taking active steps to bring us in line with the broad US equities market. (If the bet goes right, I'll be crowing from the rooftops about my genius. Maybe start a newsletter).

Other thoughts:
- I reconfirmed that the M* X-ray tool and their other resources are very handy for seeing what is in your portfolio and making informed decisions. A 14 day trial of the membership is free. If you want more time, a one-month membership is just $18.95. Yearly rates also available, but I don't look at/mess with my allocation enough to justify the expense. The search function on their site, though, is terrible.

- freebird5825: It's interesting how closely our situation parallels yours. COLA'd pension, some I-bonds, a small bit of Vanguard Energy (VGENX), some REITs (in VGSIX--now down to 4% of total portfolio).

- REITs: I think I've convinced myself that they aren't as useful in my portfolio as I'd previously believed. I put them in my portfolio long ago for inflation protection ("hard assets" undergirded them, etc) and because they had low corellation with other asset classes. Now, I'm not so sure. As we discussed here, they are really more tied to the business cycle (can owners of commercial real estate demand higher rents?), not to property values. And, REIT prices are increasingly correlated with other stocks. Per M*'s Andrew Gogerty (link may require subscription) in regards to the previous assessment that REITs offered valuable diversification to an equity-heavy portfolio:

Quote:

. . . But recent Morningstar research has rained on that parade. The correlation between U.S. REITs and U.S. large-cap stocks has been increasing at a steady pace since the beginning of the liquidity boom in mid-to-late 2000. The real strike, though, is that the category's performance is becoming increasingly more-correlated with small-value stocks, indicating that the early-decade diversification benefits may have really only been from avoiding the tech and dot com boom-and-bust cycle. With the higher cost of debt likely remaining for some time as lenders remain concerned about lower occupancy and rental rates, it's tough to pound the table for the equity returns here in the short to midterm. We're no longer sure that the risk of holding U.S. REITs is outweighed by the potential return or diversification benefits. As such, we think real estate funds--at a maximum--should be no more than 5% of a portfolio.

I don't think this reconsideration of REITs is just because they've done so poorly in the last 2 years. They just don't seem to behave in a significantly different way from holdings I've already got. traineeinvestor: I wouldn't mind finding a cheap way to get exposure to residential properties-- the actual buying owning/renting, and re-seling of them. I do think they offer inflation protection, and agree that their prices are presently depressed. This would obviously be a long-term "bet." (I don't want to be a landlord or fix-and-seller).

-charlie: CDIPs might be a good investment for some folks. I'd be worried about the abilty of some corps to make the payments in a bout of inflation big enough to upset the financial markets and business cycle. An investor should demand healthy compensation for taking that risk, IMO.

- smjsl: Regarding TIPS and taxes: I'm assumng you can't make room in tax-favored accounts (401K, IRA, etc)? One other small thing--don't entirely forget I-Bonds. Maybe someday they will offer attractive real returns again, and you'd probably want to hop aboard then. No taxes until you sell, and government backing. And yes, I think CD's could offer some inflation protection, assuming banks have to at least match inflation to get any takers. You'd want to keep the duration short (which reduces yield) so you don't get caught with 5 year 3% CDs when inflation has shot up to 8%. Bonus: The bank might send you a calendar, a toaster, or an oven mitt!

Again, sorry for the long post.