It’s time to start worrying about inflation. Although inflation has been low and fairly steady in the past decade, prices will begin accelerating in 2021 and 2022. The Federal Reserve will be slow to react, allowing inflation to accelerate for two or three years, as I argued in Higher Inflation From The Fed’s New Strategy—And More Business Cycles. Increasing inflation has implications for businesses and workers, but this article will focus on investors. What’s a good inflation hedge, and how good a job can one do?
The classic inflation hedges are gold, other commodities, real estate and, some argued, stocks. There are possibilities in all these categories, though investors should not expect any of these to work perfectly.
The answers here are speculative. We lack good data over multiple inflation spells to know for sure how different assets perform as inflation hedges, and of course plenty has changed since the early inflation episodes, such as Egypt under Ptolemy IV (221-204 BC), Rome (from Nero through Claudius II) or China during the Song Dynasty (960-1279). But history tells us that inflation can happen anywhere, typically where rulers choose to spend more than they take in from tax revenue.
Gold is the classic inflation hedge. Early inflations were caused by debasement of metal coins. A king would substitute a cheap metal such as copper for some of the gold content, keeping the extra gold for the treasury. Those who held gold itself, rather than coins minted by the government, preserved purchasing power, or so it seemed.
The actual value of gold as an inflation hedge is hard to determine for the United States, because for most of our history we were under a gold standard. That is, the dollar was defined in terms of gold, so holding gold was the same as holding dollars. However, during some inflationary periods the U.S. Treasury suspended conversion of dollars into gold. In those cases, holding gold was clearly better. (Those episodes included 1813-1814, 1837, 1862-1878, and from 1933-1968. Conversion was also suspended during a turbulent period in the 1850s that was not inflationary.)
Over the long haul, gold isn’t much of an investment. Since 1800 the price of gold has gained an average of 2.0% per year, with inflation 1.2%. So that’s a gain, but far less than a buy-and-hold investment in stocks, bonds or real estate.
A milder inflation hedge would be mining stocks, which rise with inflation but usually produce earnings even in non-inflationary times. We don’t have great data, but they are probably a better inflation hedge than stocks, but not at all perfect. Precious metals mining stocks probably provide a better inflation hedge than base metals and other commodities, but the other types may serve as a partial hedge that also provides annual returns.
Stocks used to be considered an inflation hedge, on the theory that higher prices meant higher earnings. Stocks almost kept up with inflation from 1968-82. That, however, was a disappointing result, as stock market returns normally exceed inflation by a wide margin. The problem seems to be with companies that buy raw materials or merchandise for resale, then sell the finished products at a later date. The inflationary gains are taxed as if they are productive earnings. Companies are, in effect, over-taxed in inflationary times. This will be less a problem for service businesses.