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How to Protect Yourself From Inflation

Posted By Jim On 03/01/2010 @ 7:24 am In Personal Finance | 38 Comments

One of the unintended, though predictable, consequences of the unprecedented rescue of the United States financial system is that there will be higher than average inflation figures for years to come. While it’s been popular to dispute the reported Consumer Price Index [3] (CPI), the reality is that the marketplace doesn’t really listen to the reported stats. It reacts to reality. Your boss doesn’t walk into your office and say “Oh, CPI says I need to give you an x% raise this year to maintain your purchasing power.” and the grocery store doesn’t increase the price of a head of cabbage a few cents every month because the BLS came out with another report.

So we need to be proactive and be aware that inflation is a real concern, before it becomes front page fodder for newspapers.

What is inflation?

Inflation [4] is defined as a general rise of prices for goods and services. It’s why a piece of gum that cost a nickel ten years ago now costs a quarter. Why you could get comic books for a dollar but they now cost two. It’s a slow erosion of the purchasing power of a dollar and it’s generally accepted that a low steady rate of inflation is good for an economy. The reason why inflation is a predictable consequence of the rescue is because the Treasury and the Federal Reserve introduced a lot of money into the system.

At the most basic level, imagine if you and your friends had the only grocery store in the universe all to yourselves. The owner of the store only had you as customers. The price of the products in that store depends on how much money you had, since the owner had to sell to you, he or she couldn’t hold out for other customers. There is no reason you keep any money to yourself because it’s the only grocery store available. If you all had a combined $100, then all the goods in the store had a value of $100. Now imagine if I just handed you $100. The goods didn’t change but now the total value is $200 because that’s what you have in your pocket. Each dollar is worth less because there are more dollars. (inflation is a little more complicated than that but I think you get the idea)

So why hasn’t inflation already happened? Well, partly it has to do with the demand. With millions out of work and with consumers saving more, you have fewer people going to the stores. So the pool of spenders has gone down even though the supply of dollars has gone up. Also, there’s been a tremendous amount of wealth destruction in the form of failed mortgages and lost investments. So while the printing presses seem to be going crazy, there’s a bonfire going on at the same time. It remains to be seen what sort of financial wizardry will be used to try to keep inflation in check but it still pays for us to try to mitigate the risk ourselves.

However, just because it’s not here yet doesn’t mean it won’t ever come… so how do we protect ourselves from inflation?

Buy a House

If you were to look at your budget, housing is likely one of the largest line items. If you’re a renter, and you’re in rent controlled housing, inflation will slowly increase how much you pay each year. By buying a house, you lock in a monthly payment that will only increase if (when) insurance and real estate taxes increase. You won’t have to pay more simply because inflation has sucked away some of your purchasing power. In fact, the higher inflation is, the cheaper your housing becomes because the dollar amount remains the same for the life of your loan.

The risk is that your house loses value, which is a risk of any investment, but in this case we are more concerned about inflation eroding our purchasing power. Since we are still getting the same product, housing, at the same price, it is less important how inflation affects our other dollars in this category.

Gold

The reason why gold became such a hot investment the last few years is because it’s a store of value. I think a lot of people approach gold as an investment, which is a mistake. You should think of gold more like a lockbox and less like a stock. The reason why gold is considered safe has to do with how if the United States government collapsed and the dollar became worthless, you could bring your gold to another country and exchange it for their currency. The USD would be worthless but your gold would still have some value. That’s the most doomsday of scenarios but it’s an example of why gold became popular.

So why does gold offer protection against inflation? It’s because you get to take some of your dollars and put it outside the US financial system. The problem with gold is that it also has a speculative component and is seen as a hedge against crisis (like the doomsday scenario I mentioned earlier) so you’re “paying” for that whenever you buy gold. Buying Coca Cola is probably a good investment because it’s a good company but you can take a good investment and make it a terrible one by buying at the wrong price. Unfortunately, gold is getting a lot of press now so chances are it’s not a great price.

Inflation-linked Bonds

Series I bonds [5] and Treasury Inflation Protected Security [6] are frequently touted as great places to put your money to protect it against inflation. They are not perfect but they are good enough and the principal is protected by the full faith and credit of the United States Government, unlike the value of your home.

What you get for that safety is an asset that keeps pace with inflation but won’t knock your socks off. While your home can appreciate in value faster than inflation, these Treasury bonds won’t offer much more than a chance at keeping up with inflation. You don’t get rewarded unless you take some risk and since these bonds are one of the safest, you won’t be rewarded that much.

Summary

There are no “perfect” ways to protect yourself from inflation but the three I’ve mentioned seem to be the three best ways that I’ve found. My approach to this problem was I could do one of two things – I can either lock in your expenses (housing) or you can lock in the value of your money (storing it in gold or inflation linked bonds). Beyond that, I’m not sure there are any other approaches out there.

If you have a good idea at how to combat inflation, I’d love to hear it. I’m a novice in these sorts of things so I hope to learn from you all too!

(Photo: ronnie44052 [7])


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[2] Email: mailto:?subject=http://www.bargaineering.com/articles/how-to-protect-yourself-from-inflation.html

[3] Consumer Price Index: http://www.bls.gov/cpi/

[4] Inflation: http://en.wikipedia.org/wiki/Inflation

[5] Series I bonds: http://www.treasurydirect.gov/indiv/research/indepth/ibonds/res_ibonds.htm

[6] Treasury Inflation Protected Security: http://www.treasurydirect.gov/indiv/products/prod_tips_glance.htm

[7] ronnie44052: http://www.flickr.com/photos/ronnie44052/2730972472/sizes/s/

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