Types of Inflation Hedges

[TripleB]

I started outlining all the types of inflation hedges that I know if, and the pros/cons of each. Comment on others and if you agree with my assessment:

Gold:
Good for unexpected inflation
Probably good for hyperinflation


REITs:
Leveraged asset so risky to use
Good for real estate inflation only
Might be useful to own if you are a lifelong renter since housing will be an expense in perpetuity

Chinese Yuan:
I read the Bank of China began allowing US Citizens to convert $20k of USD into Yuan annually so it's interesting to me.
Should be good for light USD devaluation compared to other currencies.
Would be bad for heavy USD devaluation.
If the Yuan appreciates slightly relative to USD, then the cost of everything in the US will go up, because stuff is made in China, and now stuff is more expensive to make.
However, if the Yuan appreciates heavily, manufacturers will move to Malaysia, Indonesia, or the Philippines, in which case the Yuan provides no protection to us. However, since the government controls the Yuan very tightly, it's unlikely they will allow the Yuan to appreciate to the level where they lose all manufacturing. And once it starts moving to that level, the Yuan will organically drop, and reach a new equilibrium.

TIPS:
Garbage because the government reports CPI using skewed calculations.

IBonds:
Still uses skewed CPI data, but the bonds have a built in put option so if inflation gets out of hand and isn't reported properly, we can sell the iBonds and move the money into a MMF, or FDIC insured account. Also there's good tax-shelter capacity here, so that outweighs the negatives of using CPI data. Not a super powerful hedge because of the annual limit.

Commodity Funds:
Leveraged so they can be risky.

Forward Buying:
If you live somewhere that you are unlikely to move from, then forward buying 6 months worth of food, and rotating through it, can be a good hedge against inflation. In theory one should still eat a reasonable amount of fresh fruits/veggies/meat, but if 2/3 of food eaten is fresh and 1/3 are canned, then the "6 month supply" of food (if eaten in conjunction with fresh foods) would really be a 2 month supply of food if you were exclusively eating it. And 2 months of food is decent.

[WildAboutHarry]

TIPS:
Garbage because the government reports CPI using skewed calculations.

IBonds:
Still uses skewed CPI data, but the bonds have a built in put option so if inflation gets out of hand and isn't reported properly, we can sell the iBonds and move the money into a MMF, or FDIC insured account. Also there's good tax-shelter capacity here, so that outweighs the negatives of using CPI data. Not a super powerful hedge because of the annual limit.

So TIPS in a tax-sheltered account are OK then?  Or is it the put option plus the tax shelter that makes I-Bonds OK?

I get the CPI risk in TIPS (yet another counter party risk!).  Assuming the CPI does correctly report inflation (or something close to it) do you agree that the mechanism of TIPS (and I-Bonds) is a reasonable way to get real returns?

Forward Buying:
If you live somewhere that you are unlikely to move from, then forward buying 6 months worth of food, and rotating through it, can be a good hedge against inflation. In theory one should still eat a reasonable amount of fresh fruits/veggies/meat, but if 2/3 of food eaten is fresh and 1/3 are canned, then the "6 month supply" of food (if eaten in conjunction with fresh foods) would really be a 2 month supply of food if you were exclusively eating it. And 2 months of food is decent.

My father used to buy great quantities of soap, detergent, canned goods, etc. during the last "great inflation" in the 1970s.  Anything that was semi-durable and semi-storeable was better than dollars to him.  So he had no shortage of those things in the 1980s, although I suspect a few cans of food went bad over the years.  And of course he missed out on the latest "new and improved" products

I'm not sure that this makes much sense when prices are reasonably stable or falling, beyond some emergency food supplies, etc., like the two-month's supply you mention.  If you do this, though, be sure to rotate your goods.

That is the nice thing about gold (and silver) as hedges against unexpected inflation and other dollar misfortunes.  Infinite shelf life.

[moda0306]

While one can argue that "core inflation" is a big skewing, this is not what CPI is... aka, food & fuel is included.

In what ways do you think CPI underreports or skews the inflation numbers?  Do you think the basket of goods is skewed too much to some purchases vs others and/or the numbers are false within these categories?

Assuming it's useful and important for a gov't to calculate inflation, I can't help but think that CPI isn't too far off from being as useful a metric as anyone could hope for. 

[TripleB]

TIPS:
Garbage because the government reports CPI using skewed calculations.

IBonds:
Still uses skewed CPI data, but the bonds have a built in put option so if inflation gets out of hand and isn't reported properly, we can sell the iBonds and move the money into a MMF, or FDIC insured account. Also there's good tax-shelter capacity here, so that outweighs the negatives of using CPI data. Not a super powerful hedge because of the annual limit.

So TIPS in a tax-sheltered account are OK then?  Or is it the put option plus the tax shelter that makes I-Bonds OK?

Technically, holding TIPS in a tax-sheltered account is not the same as IBonds because in order to use tax-sheltered space for TIPS, you forgo being able to use that limited sheltered space for something else. Thus, it's not "free" sheltered space.

IBonds expand your tax sheltered space, and thus you gain value from that.

Additionally, the put option is very valuable. If interest rates shift such that the IBond is underperforming other cash type assets, then you can liquidate the IBond and not lose principal. The same can't be said for TIPS.

In my mind, IBonds are considerably better than TIPS.

[Lone Wolf]

In my mind, IBonds are considerably better than TIPS.

I agree.  And there's more!  An additional benefit of I-bonds is that you have deflation protection each 6-month period rather than just in the aggregate.

With TIPS, if you undergo mixed periods of inflation and deflation for many years, your only guarantee is that upon maturity you'll get at least your original principal back.

With I-bonds, you'll get full principal protection every 6 months.  If hard deflation in one period yields to high inflation the next period, you still get paid that next 6-month period.

I-bonds are better than TIPS, hands down.

[Ad Orientem]

If I were betting on inflation, especially high inflation, I might consider some currency diversification.  Foreign stocks (easy enough using a global ex-US index fund) and some foreign government bonds would work well.  For the latter I would be looking for countries with very low Debt/GDP ratios.  One could also use a mutual fund.  Both have some built in downside protection in the form of yield or dividends in case you are wrong about the inflation.  And in fact both could produce very nice returns even in a non-inflationary environment.

[TripleB]

If I were betting on inflation, especially high inflation, I might consider some currency diversification. 

There's a difference between devaluation and inflation. If I was betting on devaluation (of the USD) then I'd consider currency diversification.

What I'm betting on, is inflation, and that's the devaluation of all global currencies, simultaneously, as all governments begin going on a printing spree, while their productivity declines. In first world countries, the productivity is declining due to handout entitlement programs. In 2nd and 3rd world countries, their economy depends on selling cheap labor to the 1st worlders who have created huge regulations and minimum wage laws to deter local jobs. So 2nd/3rd world nations are screwed too.

If TSHTF we will need canned food and ammo, but I'm betting on an intermediary period where we have simultaneous global devaluation of paper currencies, but things haven't escalated to widespread looting and chaos.

[WildAboutHarry]

In my mind, IBonds are considerably better than TIPS.

All good points, but you are basically dealing with a TIPS bond that has some sweeteners.  Good sweeteners.  And I think it is those "sweeteners" that will be the death knell of I-Bonds as we know them.

My I-Bond predictions:

• 2012 will be the last year you can obtain paper savings bonds
• There will be at least one more round of reducing the purchase limit
• By 2015 there will be yet another change to the program that will render it virtually useless

Will the savings bond program be eliminated entirely?  My Magic 8-Ball says "Ask again later"

[stone]

The UK long term index linked treasury bond TR8F has increased in price by >20% in the last five weeks. If you are after that kind of wacky volatility for rebalancing or whatever, then that makes it a totally different beast from ibonds I guess. Personally I got the quota of UK NSI index linked savings certificates (our kind of ibonds) but I've not got any TIPS.

[Ad Orientem]

If I were betting on inflation, especially high inflation, I might consider some currency diversification. 

There's a difference between devaluation and inflation. If I was betting on devaluation (of the USD) then I'd consider currency diversification.

What I'm betting on, is inflation, and that's the devaluation of all global currencies, simultaneously, as all governments begin going on a printing spree, while their productivity declines.

Actually inflation is the consequence of currency debasement and is normally not a term applied to all currencies unless you put the world "global" in front of it.  What you are betting on more precisely is global inflation.  I doubt that we will see a true global inflation because not all currencies have been fatally undermined by their governments.  Granted the big four (USD, EURO, GBP and YEN) are all seriously compromised by dangerous levels of debt.  But there are a number of countries whose currencies are probably pretty sound.  Canada, Norway, Sweden and Switzerland as examples all have very low, or nonexistent, Debt/GDP ratios and very conservative fiscal and monetary policies.

All of which said, I would certainly be careful about what currencies I were buying if I were hedging inflation.  I still think a global ex-US stock market index fund is a very good hedge were I expecting a severe inflation and gearing my VP for it.

[TripleB]

This is actually one reason that I split my stock portion into 50-50 US and international. In theory, during prosperity, both US and International stocks will rise, so the stock portion is working as intended.

In inflation, I get some extra hedge against USD by holding global stocks, so that helps the gold assets.

I understand it's not a popular opinion to go 50-50 US and International stock, so be warned.