How to Hedge Inflation (hint: forget gold)

[FarmerD]

Just noticed a thread on the bogleheads forum referencing Larry Swedroe's article about how to hedge inflation.

http://www.cbsnews.com/8334-505123_162- ... rget-gold/

I'm not trying to start a thread to bash Larry, but I'm curious to PPer's reaction to some of his coments in the article I've listed below:

"There's only one true hedge against the risk of unexpected inflation, and that's an investment in Treasury inflation-protected securities."

"Many, if not most, investors seem to think of the metal as a good way to protect themselves against unexpected price hikes. And they're dead wrong."

"Thus, it shouldn't be surprising that as an inflation hedge, an investment in a broad-based commodity index is superior to an investment in gold. "

"The bottom line is that there's really only one good hedge of inflation: TIPS. Investing in a broad commodities index may also offer a partial hedge, as might an investment in REITs, although a  much weaker one."

[craigr]

Just noticed a thread on the bogleheads forum referencing Larry Swedroe's article about how to hedge inflation.

http://www.cbsnews.com/8334-505123_162- ... rget-gold/

I blogged about it last night:

https://web.archive.org/web/20160324133 ... ge-hardly/

"There's only one true hedge against the risk of unexpected inflation, and that's an investment in Treasury inflation-protected securities."

"Many, if not most, investors seem to think of the metal as a good way to protect themselves against unexpected price hikes. And they're dead wrong."

When it comes to inflation I expect the stocks/bonds to outpace it realistically. But if I want to match inflation long term then I would 100% of the time bet on gold over TIPS. If inflation gets really bad there is no doubt in my mind that the first casualty with be the CPI. No government I've seen has been able to resist lying about high inflation. It's a huge political football.

Ad Orientem posted this in my comments from an article on recent budget talks:

http://www.washingtonpost.com/business/ ... ory_1.html

"The spending cuts would include $240 billion from agency budgets, about $275 billion from federal health programs and about $150 billion from using a less-generous measure of inflation in federal formulas, including the annual cost-of-living adjustment for Social Security, according to people with knowledge of the plan." (emphasis added)

So if you want your inflation adjustment being a negotiating chip on future budget talks, then by all means buy TIPS. Otherwise, skip the things and own stocks, bonds and gold. The stocks and bonds can drive real growth and the gold is there in case the currency is going haywire. Best of all, the price of gold is not subject to congressional budget talks.*

Not just this, but under high inflation I don't see any possibility of TIPS going up enough in value to offset the effects of inflation on the rest of your portfolio. Gold has a history of being able to do that however.

"Thus, it shouldn't be surprising that as an inflation hedge, an investment in a broad-based commodity index is superior to an investment in gold. "

No it's not. Central banks store gold in their vaults. They don't buy commodity futures. If you're going to own a protection for currency problems, own what the people printing the money own! Not just this, but you can control gold physically and more directly. Commodity future funds are very opaque. I'll also point out in 2008 when banks were on the verge of collapsing gold was up 5% for the year and commodity futures funds got destroyed with losses over 50% at the worst. Gold reacts to monetary crises much differently than broad commodities.

IMO, if you've made the mental leap to make space in your portfolio for a hard asset as inflation insurance, then just own the best one you can get. That's gold. It's not commodity funds and it's definitely not TIPS.

* Assuming they don't try to control it again as in the past. Which is very strange behavior for a metal that everyone says is so worthless.

[FarmerD]

Craig,
Obviously I missed your blog entry.  You make some good points regarding the CPI that I hadn't considered. 

I guess I don't look at gold as an inflation hedge.  To me, gold is a hedge against fiscal/monetary instability.  Normally fiscal/monetary instability manifests itself in the form of high rapid inflation.  The period of 1980 to 2000 was not a period of instability (it was Prosperity in Harry Browne speak) so inflation bumped along at a 2-4% clip and gold not surprisingly lost value.  Stocks and bonds adequately hedge inflation quite well during Prosperity.  Should a big spike in inflation occur, only gold has the ability to rise faster than the inflation rate thus protecting one's portfolio.  With governments around the world piling up so much debt, many people fear a replay of the high inflation 1970's.  That's why gold has gone up so much this decade. 

I'm not sure Larry understands gold as well as he claims. 

[MediumTex]

I'm not sure Larry understands gold as well as he claims.   

I am certain you are right, and I don't mean that in a disrespectful way toward Swedroe.  I think that Swedroe is in that position that a lot of smart people get in of simply overestimating the scope of their understanding of certain subjects outside of their primary expertise.

Inflation is really just the tip of a large iceberg with many sharp edges.  When you look under the waterline, though, what you see is not a printing press, but rather a lot of well-intentioned but misguided politicians and bureaucrats doing their best to keep a scheme going that is starting to see the premises on which it was conceived gradually invalidated.  To think that such a process could be subverted by simply buying a piece of paper issued by one of the parties working below the waterline of this iceberg is naive.

Like Rick Ferri, Swedroe would do well to simply say: "You know what, gold is an asset I really don't understand, so I'm not going to comment on it.  I don't personally care for it, but other investors think it has a role in some portfolios, and it might.  As for me, I'm a TIPS man."

[melveyr]

I don't see gold as simply an inflation hedge, but rather a key componenet of an overall strategy that provides consistent inflation adjusted returns. In this framework, the fact that gold underperformed inflation in the 80s is of no concern to me because bonds and stocks more than made up the difference. Gold might not be the best inflation hedge in every portfolio, but when part of the PP it helps the portfolio move towards greater inflation adjusted consistency.

[stone]

FarmerD

With governments around the world piling up so much debt, many people fear a replay of the high inflation 1970's.  That's why gold has gone up so much this decade.

I'm not at all sure that fear of what developed world currencies is the whole picture. The gold price over the last decade has been driven by buyers in India, China and Vietnam. Their purchasing power has increased a lot. My guess is that if the USA, Europe and Japan had all had austerity programs with Greek style permanent recession, mass unemployment, no monetary expansion and persistent deflation; then increasing prosperity in Asia would still have pushed up the gold price.

[HB Reader]

I'm not sure Larry understands gold as well as he claims.   

Inflation is really just the tip of a large iceberg with many sharp edges.  When you look under the waterline, though, what you see is not a printing press, but rather a lot of well-intentioned but misguided politicians and bureaucrats doing their best to keep a scheme going that is starting to see the premises on which it was conceived gradually invalidated.  To think that such a process could be subverted by simply buying a piece of paper issued by one of the parties working below the waterline of this iceberg is naive.

MT --

I like that analogy.  I wish I had thought of it.

You should put that in your book.

I guess we all place our bets and take our chances.  Like you I also respect the opinion of Larry Swedroe, as well as the well-intentioned politicians and bureaucrats.  But I've lived long enough and seen enough to know there is much more to the story than they seem willing to acknowledge. 

[Wonk]

This is a really important topic to discuss because the confusion about why gold does what it does is what drives the skepticism of the anti-PP crowd, including the Swedroes & Ferris of the world.  Indulge me for a minute...

A long time ago(and for various reasons already discussed), gold became a universal way to store value.  That value could be in the form of land, labor, commodities, etc.  When someone wanted to trade one form of value for another, the most common denominator--and therefore the medium of exchange--became gold.  As we can imagine, transporting and storing gold can become cumbersome--enter goldsmiths.  Goldsmiths securely stored gold and in exchange, issued gold receipts.  Not long thereafter, instead of exchanging physical gold, people began exchanging gold receipts.  This works out well for everyone because what people really want is to exchange value with others easily and know that their purchasing power stays constant. 

When governments decided to get in the game, the issuing currency was typically denominated in a way that allowed easy convertibility back into gold on demand.  So long as purchasing power stays steady, there's no reason to do that as we've already established that gold is a pain in the ass to transport and store.  However, when the owners of a currency find that their purchasing power is being stolen--they resort back to gold to preserve it.

Swedroe is technically right when he says gold is not a hedge against inflation.  The only thing we need to do is look at the period from 1980-2000 to see this.  There was plenty of inflation, but the gold price dropped anyway.  That's not a very good hedge.  What he and many other anti-gold folks miss, is that gold is a default hedge, not an inflation hedge.  A hard default is obvious.  That's Greece & Argentina.  A soft default is theft of purchasing power through negative real interest rates.

In the 70's inflation could continue to grow because the Fed never got short rates far enough ahead to make the dollar a more favorable investment than gold.  That stopped when Volker entered the room.  When T-Bills pay a positive rate above inflation, there's no incentive to purchase gold.  Your purchasing power is holding steady--so it's easier and more convenient to store your value in the currency.

When the PP folks debate with the boglehead folks, it's essential this part of the argument is correctly stated.  Otherwise, it's way too easy for the anti-gold crowd to blow a hole right through the "gold is an inflation hedge" argument.

[stone]

I guess the way to put is to say that gold is a negative real interest rate hedge rather than being an inflation hedge. BUT I still think gold being a link to the global economy is also a really vital part of what it does. The 40% rise in gold price in GBP terms in 2008 versus the fall in gold price in JPY terms in 2008 really brings that home starkly.

The history story about gold being a medium of exchange then gold smiths then government doesn't actually fit in with the real historical evidence of what actually happened though. There was government money and credit money thousands of years ago. I totally agree though that gold is miraculous for tracking so many values to within an order of magnitude for thousands of years.

[Wonk]

I guess the way to put is to say that gold is a negative real interest rate hedge rather than being an inflation hedge. BUT I still think gold being a link to the global economy is also a really vital part of what it does. The 40% rise in gold price in GBP terms in 2008 versus the fall in gold price in JPY terms in 2008 really brings that home starkly.

UK front ran monetary policy, whereas Japan reacted post crisis with ZIRP + QE.  I'm not saying the gold price turns on a dime--it doesn't.  More like a gigantic pendulum with inertia in one direction until a greater force moves it into another direction.  You make a great point regarding gold being a link to the global economy.  In the modern era, gold had been the preferred means of settling international trade until only 40 years ago.  The current arrangement is not advantageous for US trading partners primarily because the US can debase its currency on demand and export inflation to dollar investors worldwide.  I don't think there's any question US monetary policy is a major reason why gold demand is off the charts in Asia, where most of the trade deficit is pegged.

The history story about gold being a medium of exchange then gold smiths then government doesn't actually fit in with the real historical evidence of what actually happened though. There was government money and credit money thousands of years ago. I totally agree though that gold is miraculous for tracking so many values to within an order of magnitude for thousands of years.

Got me.  I was going to write about how the Romans diluted the precious metal content of coins, but in the interest of brevity I decided to fast forward to the last thousand years only.