5 things you can do now to prepare for rising inflation
— -- We all have our little fears: The frayed wire on the coffee maker. That knocking noise from the left-rear tire. The zombies staggering around in the backyard.
For investors, one of the biggest fears today is inflation — a period of rising prices. Inflation erodes the buying power of your money at home and abroad. In a worst-case scenario, it can result in hyperinflation, when a wheelbarrow of bills won't buy a loaf of bread.
Right now, inflation is deader than an army of zombies. But massive government borrowing raises the fear that inflation will rise from the grave and eat your savings. But you can fight back — with five inflation-fighting investments.
The consumer price index, the government's main gauge of inflation, has actually fallen 0.4% the past 12 months that ended in March. A big drop in energy prices was behind much of the drop. And in March, prices of food, housing, clothing and transportation fell. It's no wonder that the government is more worried about deflation — a period of falling prices — rather than inflation. In a deflationary period, falling prices drive companies out of business, debts become progressively more onerous, and consumers put off buying because they figure prices will always be lower later.
To get a true inflationary spiral, you need low unemployment and soaring salaries, neither of which is happening today. The unemployment rate stands at a recessionary 8.5%, and average weekly earnings fell in March.
Worries about inflation are "very premature," says David Wyss, economist for Standard & Poor's. "People are trying to fight the last war." The Bank of Japan prolonged that country's recession for a decade by using inflation-fighting tactics instead of deflation-foiling strategies, he says.
Even if inflation isn't a problem now, however, the massive government debt is one very good reason to fear inflation in the long term. Currently, the U.S. government has $11.2 trillion in outstanding debt, up from $5.7 trillion at the end of 2000. Furthermore, the government's efforts to prop up the banking system will add billions more to the total.
The root cause of inflation is too much money chasing too few goods and services. The big worry: Rather than pay off the debt, the government will simply print more money, and that's inflationary.
In the short term, then, inflation isn't a big problem. As time goes on and the deficit rises, however, inflation could become an enormous problem.
Normally, the Federal Reserve fights inflation by raising short-term interest rates, which is devastating to both stocks and bonds. Rising rates hurt corporate earnings by increasing borrowing costs. And bond prices fall when interest rates rise.
But some types of assets do rise in value in inflationary times. So if you're worried about inflation, you can make a few moves now to lessen inflation's bite with inflation-beating investments: Treasury Inflation-Protected Securities, gold, commodities, real estate and money market mutual funds.
TIPS: Value rises with the inflation rate
Treasury Inflation-Protected Securities, or TIPS, are long-term IOUs issued by the government. Like other Treasury securities, TIPS pay a fixed rate of interest until they mature.
Unlike other Treasury securities, however, TIPS have an inflation kicker: The government adjusts the principal of TIPS up or down every month according to inflation. If inflation were 3% over the previous year, for example, the government would add 3% to your bond's value.
The yield on 10-year TIPS reflects Wall Street's belief that inflation is no danger: It implies an inflation rate of about 1.3% for the next 10 years. If traders are wrong, TIPS could be a bargain now. In addition, the government uses the consumer price index as its inflation measure — a figure that includes energy. If the price of oil were to surge, TIPS would benefit.
Tips:
• You can buy TIPS directly from the U.S. government at no cost. Go to www.treasurydirect.gov to find out how.
• Top-performing TIPS fund: American Century Inflation-adjusted Bond ACITX, up 24% the past five years.
Gold: No matter what, it's worth something
Paper money may lose its value, but gold is always worth something. The problem: The price of gold isn't tied terribly tightly to inflation.
For example, the price of gold has barely budged since its 1981 high of $850 an ounce. On the other hand, gold has doubled the past five years, a period of tame inflation. "Gold has been a terrible proxy for inflation since 1981," says Ray Ferrara, a financial planner in Clearwater, Fla.
One reason: Gold prices move opposite the value of the U.S. dollar, rather than tracking inflation. But if inflation does roar, the value of the dollar will fall, too. After all, if a dollar buys less at home, it will be worth less abroad.
Tips:
•Buy gold bullion coins, such as the American Eagle or Canadian Maple Leaf. Take possession of the coins. Scammers love to pretend to store them for you.
•Consider a gold bullion exchange traded fund, such as the SPDR Gold Shares ETF GLD. Each share equals one-tenth of an ounce of gold, minus the fund's expenses.
Commodities funds: Prices of materials rise with other prices
Inflation is, by definition, a period of rising prices — not just for gold, but for virtually all basic materials, such as steel, coal, oil and lead.
Clearly, buying a boxcar full of coal has its drawbacks. And small investors who invest in commodities via the futures markets lose early and often.
But you can invest in commodities via exchange traded funds. These funds typically track a commodity futures index, such as the Goldman Sachs Excess Return index, which tracks 24 commodities.
Be aware that many commodity funds have big weightings in energy — which is fine, if that's what you want. TheiShares S&P GSCI Commodity fund GSG, for example, is 67% invested in energy.
Tips:
•The PowerShares DB Commodity index fund DBC is a highly diversified commodity fund.
•Consider an actively managed natural resources fund. Two funds that have consistently beaten their peers are Vanguard Energy (VGENX) and ICON Energy ICENX.
Real estate: Not so great now, but a good hedge
If you own a home, you probably have plenty of real estate. Despite the dismal state of the real estate market, however, your home can be a significant inflation hedge in the future.
Home prices — absent a bubble — mirror the consumer price index fairly faithfully. And if you have a low-rate, 30-year, fixed mortgage, your note will become a thing of beauty as prices rise. Your home value will rise, your salary will rise, but your mortgage payment won't. In addition, you'll repay the loan with cheaper dollars.
The catch: Interest rates tend to rise at the end of an inflationary period, squeezing new home buyers out of the market — and forcing prices down.
Real estate funds invest in real estate investment trusts, orREITs, which have had the paint peeled from them in the past few months. REITs invest in commercial real estate, and that market is starting to crumble.
Tips:
•Top real estate fund: CGM Realty fund CGMRX, up 26% the past five years.
•Realty Income REIT O strives to pay regular dividends; current yield is 8%.
Money market funds: Yields pace inflation
Strictly speaking, a money fund doesn't fight inflation. But over time, money fund yields tend to keep up with inflation, and that's important.
In an inflationary period, the last thing you want is an investment whose yield is fixed — such as a fixed-rate annuity or a bank CD. Your interest payments will buy less each passing month.
Money funds, which invest in short-term, high-quality IOUs, can't guarantee a set yield. They can only give you what the short-term money market has to offer.
But as the Fed begins to fight inflation by raising interest rates, your fund's yield will rise, too. You won't get rich, but at least you'll keep up.
Tips:
•Don't bother with Treasury-only money funds; you don't need them. You can buy three-month Treasury bills directly from the government at www.treasurydirect.gov.
•Look for funds with the lowest expenses. At today's rates, you need to keep all the yield you can.
John Waggoner is a personal finance columnist for USA TODAY. His Investing column appears Fridays. new book,Bailout: What the Rescue of Bear Stearns and the Credit Crisis Mean for Your Investments, is available through John Wiley & Sons. Click here for an index of Investing columns. His e-mail is jwaggoner@usatoday.com. Twitter: www.twitter.com/johnwaggoner.