What to Do About Inflation—and What Not to Do

Many consumers think inflation is on the way. Here’s how to hedge against price spikes.

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American consumers have had plenty of things to worry about over the past year, but inflation has not been one of them. From the end of 2008 to the end of 2009, the consumer price index rose 2.7 percent, much lower than the 4.1 percent growth in 2007. 

But many Americans are worried that prices will rebound—big time—in 2010. A December survey from the Conference Board found that consumers expect a 5.1 percent increase in general prices over the course of this year. Such a gain wouldn't be small potatoes. The CPI has not gone up by more than 5 percent in one year since 1990, when the Iraqi invasion of Kuwait caused the price of oil to spike. A strong uptick in inflation would be damaging to consumers, especially on the heels of a recession. To put it into perspective: "If inflation averaged 5 percent, that would cut your buying power in half in 14 years," says Greg McBride, senior financial analyst at Bankrate.com. 

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Investors also are getting jumpy: The price of gold, a traditional hedge against inflation, rose during the recession and rallied 24.8 percent against the dollar last year. "People are concerned about inflation, and that's why the price of gold has been going up," says Steve Hanke, an economist at Johns Hopkins University. 

The main cause for that concern is the recent increase in government spending and the debt needed to finance it. The International Monetary Fund has predicted that without tax increases or major spending cuts, U.S. government debt will rise from about 94 percent of the gross domestic product this year to 108 percent in 2014. The theory is that massive amounts of borrowing tend to weaken the dollar's value by forcing the expansion of the money supply through increased issuance of U.S. treasury bonds and also by making foreign investors less likely to want treasuries. 

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Economists are divided about whether inflation will materialize. A survey of economists released last year by the National Association for Business Economics found that about 50 percent think the Federal Reserve Board will be able to keep inflation down over the next couple of years, while 41 percent think significant inflation is likely. 

If inflation comes roaring back soon, the savings and investments of a great number of Americans will suffer because many have not considered inflation-hedging strategies, says John West, a director at Research Affiliates. The usual investment strategies often do not work when inflation is high. For example, many stocks tend to do badly with inflation because prices increase without an increase in value. Your stock portfolio is not worth as much in a high-inflation environment. 

Preparing for inflation requires a look at assets whose value can resist a weakening dollar or rising consumer-good prices. "You want to invest in things with real tangible value," says Rich Toscano, a financial planner with Pacific Capital Associates. But common inflation hedges are not always safe bets. Here are three of the most common assets investors flock to when fears of inflation are high. 

1. Treasury inflation-protected securities. TIPS are one such hedge. These are government-issued bonds whose principal is tied to the inflation rate as measured by the CPI. While treasuries are usually seen as very safe investments, TIPS could be problematic for investors if the predictions of government debt weakening the dollar come true. "In most people's minds, they think of inflation going up across the board. That's oversimplified," says Toscano. "If there was to be a genuine global revulsion against treasuries, rates could go up more than inflation goes up." If foreign investors were to demand fewer treasury bonds, interest rates would most likely go up and the value of the dollar would drop. The CPI might not immediately reflect a fall in the value of the dollar stemming from a fall in treasuries, since general weakness in the economy or other factors could keep the prices of other goods down. Rising treasury yields would bring down the principal paid to the TIPS holder, but the CPI would not be rising at a fast enough rate to increase the principal.