To many economists, inflation will be the unavoidable result of federal deficits and the economic recovery.
They posit that the Federal Reserve will have no choice but to pay off the $12-trillion the Federal government already owes and the additional $6-trillion it’s expected to borrow over the next five years. It will do that by pumping more and more money into the economy by creating the cash it needs to buy more and more Treasury securities. That’s called monetizing the debt, and that will make dollars worth less. Ergo: Inflation.
At the same time, the Treasury will have to raise interest rates to keep attracting foreign buyers to their bill, bond, and note auctions. Those higher interest rates will get built into the prices of every business that relies on credit to exist — or relies on businesses that rely on credit. Ergo: Inflation.
That is not a foregone conclusion. Fed Chairman Ben S. Bernanke has told Congress the Fed “will not monetize the debt.” Some analysts believe it will be impossible for the government to pay off its debts with cheap money, because such a large amount of spending is already indexed to inflation. Programs with cost-of-living adjustments, like Social Security, would simply see their costs increase as inflation rose. That would compound the inflationary effect without reducing the debt.
So, even if Bernanke and his colleagues are dead set against creating $18-trillion super-cheap U.S. dollars, the average investor would be smart to prepare for at least a little bit of inflation and the rising interest rates that go along with it. Here’s how.
Don’t assume that we can’t have runaway inflation along with the recession’s continuing job market weakness and suppressed salaries. That is exactly what happened in the 1970s: High unemployment and runaway prices. The decade ended in 1980, during which unemployment was 7.5 percent, the prime rate hit 20 percent and the Consumer Price Index rose 14 percent.
Be aware that interest rates and prices don’t move in lock-step. Interest rates could well rise much faster and more precipitously than prices. That could be a big problem for investors who think Treasury Inflation Protected Securities (TIPS) offer total protection. They do protect the value of investors money in times of consumer price inflation, but they don’t offer much protection against runaway interest rates.
Don’t rush into gold. While the price of gold and other precious metals typically protects against inflation, it’s already been bid up considerably by investors wanting gold as a hedge against economic uncertainty and the prospects of that cheaper dollar. In 2005, gold was hovering below $450 an ounce. Last week it topped $1,200. That’s means it’s already got a 23 percent annual inflation rate built into the price. Gold bubbles may sound like a nice concept in jewelry, not so nice in your investment portfolio.
Be very careful about long-term bonds. Nobody gets as slammed in a rising price/rising rate environment as people who have money tied up in long-term bonds. The value of their bonds crashes as market rates rise. “You don’t want to have money in long-term bonds,” warns David Hultstrom, a money manager in Woodstock, Georgia. He suggests that investors keep the fixed-income portion of their portfolios in short-term bonds, including TIPS.
Think of conservative measures. Here’s an inflation hedge: owning your own home. This is even better: pay for it with a long-term, fixed-rate mortgage. “that is an outstanding inflation hedge, since future payments will be made with cheaper dollars,” says Hultstrom. Another conservative way of preparing for rising interest rates is by buying your bonds and bank certificates of deposit over time and not all at once. Investment pros call this building a ladder. If, for example, you had $25,000 to invest in CDs, you could split it into five different amounts and buy five different CDs — putting $5,000 each into a one-year, a two-year, a three-year, a four-year and a five-year CD. As each matured, you could roll it over into a 5-year CD. That would give you the higher rates of the longer term CD. The added bonus — that one-fifth of your money would become available for reinvestment every year — would protect you from having too much of your money locked into fixed-rate investments as interest rates rose.
Fill in with alternative investments. Don’t go overboard hedging against inflation, but some other investments that typically do well in inflationary times are international stock and bond funds that are not hedged for currency risk, real estate investment trusts, and most commodities.