How to Understand and Protect Yourself From Inflation

by Philip Brewer on 13 June 2012 (9 comments)

This article was made possible by support from OppenheimerFunds.

At the time of Julius Caesar, the monthly pay for a Roman legionary soldier was one aureus — a gold coin that weighed about 8 grams (just over one-quarter of a troy ounce) and was enough money to buy 200 pounds of flour. Eight of them were enough to buy 23 acres of woodland in Kent.

That much gold would be worth a bit over $400 today — which will buy you perhaps 500 pounds of whole wheat flour (maybe 1,000 pounds of white flour). You'd have to be looking at some pretty remote places before you could find 23 acres for $3,300, but there's land that cheap. 

During the next three hundred years, there was inflation in Rome. The aureus shrunk to 7.3 grams and then 6.5 grams and then was replaced by a new gold coin that weighed 5.5 grams.

They used a different strategy for their silver coins. Instead of shrinking them, they debased them with base metals. The value of the main silver coin, the denarius, collapsed. One of Julius Caesar's soldiers could have bought an aureus for 25 denarii. Three hundred years later, it took 275,000 denarii to buy even the new, shrunken gold coin.

Take a guess at just how high the inflation rate needs to be to produce that sort of collapse in value. I'll give you the answer in a bit.

The Gold Standard to Fiat Currencies

People always talk about inflation as if there were some golden age when we were blissfully free of it. That isn't really true, but it was kinda true during the age of the gold standard. For a couple hundred years, during the eighteenth and nineteenth centuries and up to about 1930, you could make really long-term plans knowing that your British pounds and U.S. dollars would be worth as much to your children and your grandchildren as they were to you.

The experience of the Great Depression changed everything. Since then the common wisdom has been that, although inflation is bad, any past inflation should be accepted as a done deal. Inflation should be kept low, but no attempt should be made to reverse it.

The result has been that, unlike during the nineteenth century — when you could leave your daughter an income of a few hundred pounds a year and be confident that she'd be as well off in her old age as in her youth — everybody who makes plans has to think about inflation. 

How Bad Is Inflation Going to Be?

Let me give you two numbers.

The first is 7.8%. That's the inflation rate from 1971 (when Nixon closed the gold window, ending the last vestige of the gold standard) through 1983 (the end of Paul Volker's first term as Chairman of the Federal Reserve). By the end of that period, it would have taken $2.46 to buy what a dollar would have bought at the beginning.

The second is 3%. That's the inflation rate for the two periods before and after that, from 1933 (when the U.S. went off the gold standard as far as ordinary people were concerned) until 1971, and from 1983 through today. In both periods, inflation turns out to have been almost exactly 3%.

Oh, and you remember the terrible Roman inflation that made the value of the denarius collapse so that it took 275,000 to buy what 25 would have bought three hundred years before? That also works out to an inflation rate of just about 3%. That's all it takes to destroy your money if you give it three centuries to do its work.

If I were making plans, I'd bet that about 3% is the most likely inflation rate. As you can see, there is ample historical precedent. I'd be surprised to see a rate higher than 7.8%.

At an inflation rate of 3%, your money loses half its value in 24 years. Ordinary people make plans that stretch off for that long or longer — when they're planning their career, when they're planning their retirement, when they're planning to take out a mortgage to buy a house. Failure to plan for inflation may be disastrous for individuals who are surprised by the devaluation of their savings and assets. But the distortions to the real economy from a 3% rate are minimal, especially if the rate is fairly steady.

Higher rates, on the other hand — especially rates that begin to approach 7.8% — are completely untenable. Not only is the value of cash destroyed quickly, but long-term planning is also impossible, because rates that high are unstable. Will they spike up to 15%? Return to 3%? There's no way to guess. Worse, a rate that high imposes real costs on the economy. Because no one can count on prices being stable even from day to day, people have recheck prices for every routine transaction.

Given that inflation can change or even ruin long-term financial plans, what's our best move to protect our wealth? 

Four Ways to Protect Your Savings From Inflation

For inflation protection, the first suggestions are always gold, inflation-indexed securities, cash, and equities.

Gold

Over the centuries, gold has held its value like nothing else. Over the decades, though, gold is sometimes pretty crappy. You'd have had to spend over $500 to buy an ounce of gold in 1979 or 1980 — and gold wouldn't be worth that much again until 2005. For most of two decades you'd have been sitting on a loss.

On top of that, the value of gold doesn't grow — a stash of gold coins will buy about as much flour or land as it would have bought 20 centuries ago.

That's not to say that gold doesn't have a place in your portfolio, but it was a lot more appealing during the couple of decades when you could buy it for $300 an ounce than it is now.

Inflation-Indexed Securities

The U.S. Treasury issues several inflation-protected securities, called TIPS. They pay a yield set at auction for the life of the bond — but they pay that yield on principle adjusted for inflation. If you'd bought a 3% 10-year TIPS bond in 2002, it would be paying that rate on its inflation-adjusted value, which is closing in on $1,280, and might well reach it before the bond matures next month.

There are several downsides to TIPS, one of which is that you have to pay taxes on the inflation adjustment annually, even though you don't actually get the cash until the bond matures. Another is that the yields have collapsed to near zero (and in fact are currently trading at levels that imply a negative interest rate). 

One special case of inflation-indexed security is the Series I Savings Bond, which is actually rather interesting right now. It also pays inflation plus a fixed rate, and its fixed rate is also zero at the moment — but can't go negative. A bond that you buy today will yield a return equal to the inflation rate — and will yield that return for almost any time period you want. You have to hold it for one year, but after that you have the option of cashing it in any time you want or holding it 30 years. (There's a penalty of three months interest if you cash it in after less than five years, but that will be very small unless inflation gets quite high — and if inflation gets quite high, you'll probably want to keep the bond anyway.)

The main downside of Series I Savings Bonds is that you're limited to buying $10,000 per year. If you're a small investor, that's probably not a serious obstacle.

Cash

Very short-term investments like T-bills or money market funds usually yield enough to stay ahead of inflation. The return on cash was almost always several percentage points above inflation from 1960 to 1990.

Sadly, that's not true any more. For most of the last decade, cash has paid less than the inflation rate, because central banks are holding rates down to minimize the harm of the financial crisis.

Until the central banks relent, the yield on cash is too low to protect you from even small amounts of inflation.

Equities

Investing in the stock market provides inflation protection, because the companies are working in the real economy — buying and selling things that have real value.

During a period of inflation, companies will face rising costs for the things they buy and the wages they pay their workers — but they'll generally be able raise the price of the things they sell by a similar amount.

The result is that investing in stocks during an inflation isn't too different from investing in stocks any other time. You want a diversified portfolio. You want your money invested in companies with good management in a profitable business. If you do that, the inflation thing will sort itself out.

Candy Bars

A final inflation example — how about candy bars? The ones your parents or grandparents will have told you cost a nickel when they were kids, the ones that cost $1 now? What will they cost in 2050?

If inflation ran at 7.8%, they'd cost close to $20, but I don't think that's at all likely. An inflation rate that high would do such serious damage to the economy that it could never be sustained for decades.

Nope. I'm willing to bet that inflation will continue on at about the same 3% rate that we've seen over and over again for the past 2000 years. If I'm right, they'll cost about $3.

The opinions expressed in this post are solely those of the author.

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Guest

You might want to read about the Permanent Portfolio: http://crawlingroad.com/blog/2008/12/18/the-permanent-portfolio-allocation/

Its designer, Harry Browne, was worried after the US pulled off the gold standard in the early 1970s and needed a way to hedge that. So he created a low-maintenance investment portfolio that stayed ahead of inflation (for most years) while providing very little volatility (2008 was a positive year although it didn't stay ahead of inflation.)

Philip Brewer's picture

Yeah, I'm familiar with the Permanent Portfolio from way back. It's a reasonable take on asset allocation among a similar set of asset classes.

Guest's picture

Great overview of inflation and how to protect yourself from loss of values over time. I always assumed that stock portfolios would be the most protected from inflation, but never knew why until now. And although candy bars sounds like a very entertainment investment option, wouldn't your arguement work for just about any asset? Cabbage? Beef? Water?

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Marvin

As far as stocks are concerned, another option would be to buy into funds that invest in international companies that don't hedge the dollar.

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David N.

Compliments to the author. This is very well written article. Thank you.

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Sara Young

"An inflation rate that high would do such serious damage to the economy that it could never be sustained for decades."

You are completely right. Most people do not understand what inflation is and the effects it could have on their day to day lives. great article by the way, you made the terms so simple so we could understand it.

Guest's picture
Drew C.

"At an inflation rate of 3%, your money loses half its value in 24 years."

So hard to believe, but it's true.

Guest's picture
David

Philip, I appreciate your insight on inflation. Not an easy topic to discuss and you do a great job of explaining. Thank you.

- David

http://FinancialBin.com

Guest's picture

While gold is a hedge, it's not the best. Commodities in general are hedges against inflation (more dollars means higher commodity prices), so if you want to hedge against inflation, then you should buy the commodity that rises the most (in effect, has the most volatility). In this case, I'd recommend silver.