How to Hedge Against Inflation

Learn what it takes to hedge against inflation and protect your finances

enior couple sitting at the kitchen table looking at digital tablet and recalculating their expenses because of inflation

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Inflation is the loss of purchasing power of a currency, and poses a significant risk to the ability to keep up with the cost of goods and services over time. The effect it has on investors’ portfolios is also important. The real rate of return represents the return after the impact of inflation. If your salary goes up 2% and your portfolio has a 7% return, but inflation is 8%, your salary and portfolio will lose 6% and 1% of their purchasing power, respectively. 

Consumers and investors need to take inflation into consideration, and may want to hedge against inflation. Investors have a number of ways they can hedge the exposure of their investments to inflation, including having a diversified portfolio, choosing different types of assets, and finding higher yielding investments. This article will discuss the types of inflation and strategies for hedging against it.

How to Hedge Against Inflation 

Understand the Basics

When people say their dollar does not stretch as far as it used to, they are talking about the effects of inflation on their earnings or wealth. Inflation reduces the purchasing power of their money, so each person prefers their earnings and investments to outpace inflation so they are able to afford more things, even if their prices rise. 

Each nation has its own inflation rate, which is a function of its overall economy as well as the impact that its fiscal and monetary policies have on its economy. Inflation can also impact specific areas of an economy, such as the cost of gas or food. There are three types of Inflation that impact an economy: demand-pull inflation, cost-push inflation, and built-in inflation.

What Is Demand-Pull Inflation? 

The common expression that inflation is too many dollars chasing too many goods is what is referred to as demand-pull inflation. This type of inflation, which results in higher prices for goods and services, is the result of an increase in demand and/or shortages of desired products. Demand-pull inflation impacts consumers through higher prices, and is often associated with easier monetary policy that causes an excess of dollars in the economy, which increases demand for goods.

What Is Cost-Push Inflation? 

Cost-push inflation is a rise in the price of products due to producers passing on increased wage and raw materials prices. Also known as wage-push inflation, cost-push inflation results from the general rise in prices due to inflation. Higher prices from wages, which workers demand to keep up with inflation, and materials, which go into the production of goods, often result in a lowering supply of goods. This shifts the supply and demand equation for the product that results in higher prices for products and services. 

What Is Built-In Inflation? 

Built-in inflation is the expected level of inflation in an economy, and is based on past levels of both cost-push and demand-pull inflation, as well as the overall business cycle. Built-in inflation drives economic expectations and planning in an economy. Built-in inflation impacts consumers as the general level of expected inflation filters through the economy, and it also impacts investors that look to obtain high real rate of returns, which is the return on an investment after inflation.

Know the Risks

Inflation Negatively Impacts Purchasing Power

Inflation reduces the purchasing power of your money, so you can’t buy as many things with the same amount of money. If your salary remains the same and there is inflation, you may not be able to buy everything you need without having to borrow money for the difference. If you can still afford all the things you need, you won’t have as much money on hand to invest or spend on leisure activities or other things you may want to purchase.  

Inflation Raises Interest Rates 

Low interest rates have the effect of expanding the monetary base, as more businesses and consumers will be willing to borrow money to expand their business or spend on things like cars, houses, and any other items. Government spending also involves borrowing money, and this also expands the monetary base. The result of this is demand-pull inflation. 

This is why the Federal Reserve Bank monitors interest rates. It wants to keep rates as low as possible to expand the economy, but does not want this to happen so fast that it creates too much inflation. When there is too much inflation, the Fed can raise rates to lower borrowing and restrict credit in an effort to bring inflation down.

Inflation Increases Recession Risk

Inflation can cause a risk of recession because people may stop buying goods and services when they do not have enough purchasing power to keep buying them. It can also cause a recession when the Fed raises interest rates to cool the economy in an effort to combat inflation because businesses and people may not want to borrow at higher rates. This reduction in business activity can cause a recession.  

Compare Some Top Online Brokers for Hedging Against Inflation

Platform  Account Minimum  Fees
Merrill Edge $0 $0.00 per stock trade. Options trades $0 per leg plus $0.65 per contract
TD Ameritrade  $0 $0.00 for equities/ETFs.$0.65 per contract for options.Futures $2.25 per contract
E*TRADE $0 No commission for stock/ETF trades. Options are $0.50-$0.65 per contract, depending on trading volume.
Fidelity $0 $0 for stock/ETF trades, $0 plus $0.65/contract for options trade
Interactive Brokers $0  $0 commissions for equities/ETFs available on IBKR’s TWS Light, or low costs scaled by volume for active traders that want access to advanced functionality such as order routing. $0.65 per contract for options on TWS Light; that is also the base rate for TWS Pro users, with scaled rates based on volume. $0.85 per contract for futures.
Charles Schwab $0  $0 for stock/ETF trades, $0.65 per contract for options

How to Hedge Against Inflation 

Hedging against inflation requires some thought about your portfolio and mix of assets, but there are a number of options that can help counter inflationary periods. We will now look at some of these options for hedging against inflation in greater detail.

Here’s how it works. 

1: Invest in Treasury Bonds

US Treasury bonds are often looked to by investors for the income they provide. Treasury securities are debt instruments taken out by the U.S. government (other nations also issue their own bonds), and they pay interest and also return the principal. U.S. Treasuries are popular as investments because they retain a high credit rating and because they generate a consistent income for their investors with a near certainty that they will not default. Retirement investors often increase the percentage of bond holding in their portfolios relative to stocks because you will not lose principal owning a bond if you hold it to its maturity.

However, while U.S. Treasuries generate interest income and return principal to their investors, their value is impacted by interest rate levels, and interest rates change in response to inflation. U.S. Treasury prices move in the opposite direction of interest rates. The two general types of U.S. Treasury debt products are as follows: 

  • U.S. Treasury bills, notes, and bonds: These are debt instruments that pay interest and return principal. The interest rate for bills, which have maturities of one year or less when issued, are based on their price, which are priced at a discount to the maturity price of 100. Notes and bonds all have a fixed interest rate set when they are issued. The value of treasury bonds falls when interest rates move higher and rises when rates move lower, because the relative value of the fixed interest payments changes based on the interest rate than can currently be obtained. Otherwise, nobody would buy an existing bond with a lower interest rate. Further, longer maturity treasuries, because they receive more interest payments than treasuries with shorter maturity dates, will have greater price volatility than shorter maturity ones because of the change in interest rates. It is important to understand, therefore, that shorter-to-maturity bonds are safer investments than longer maturity bonds when interest rates are moving higher.
  • Treasury Inflation-Protected Securities (TIPS): TIPS are bonds issued by the U.S. government that are designed specifically to protect investors from high inflation. The bonds periodically adjust the principal amount on the investment based on the inflation rate in order to preserve the purchasing power of the bond’s principal. TIPS are a popular investment for people looking to preserve the purchasing power of their investment in U.S. Treasury debt. 

2: Purchase Gold and Precious Metals

Gold and precious metals have been coveted by civilizations and individuals for thousands of years. This is because, aside from the beautiful things that can be made with them, gold and precious metal prices have retained their purchasing power  (the value of a currency in terms of how many products and services it can buy) remarkably well. Further, gold and other precious metals, such as silver, platinum, and palladium, are easily traded in liquid markets, and are both durable and malleable. Because these assets are held by nations and investors alike, gold and precious metals trading can be volatile as the world adjusts to changing events and news. While the U.S. dollar used to be backed by gold, it no longer is, making the dollar a fiat currency, which is a currency not backed by a physical commodity.   

Inflation may reduce the value of a currency, but gold and precious metals have held their relative value and purchasing power remarkably well throughout history. While they have not always been in favor with investors because they are not an income-providing asset, like bonds or stocks that pay a dividend, gold and precious metals can still play a role in a modern portfolio. In addition, they have typically been in vogue during inflationary periods because they have historically preserved purchasing power. 

3: Fund a High-Yield Savings Account

High-yield savings accounts offer significantly higher interest rates than traditional savings accounts offered at most banks where customers have their checking accounts. With online banking more widespread and adopted, there are now many online banks that offer very few services, but much more competitive interest rates on savings. Typically, these investments need to be a minimum of $5,000 to obtain favorable rates. While most investors may not put a large part of their overall portfolio into a high-yield savings account, it may be a worthwhile option for investing an emergency fund compared to the low rates offered by more traditional banks. 

4: Invest in the Stock Market

While inflation can negatively impact stock prices, and a rise in interest rates may lead to a recession, that does not mean investors should sell out of their entire stock portfolio. Historically, long-term investing in stocks has benefitted investors looking to build wealth. Having a well diversified portfolio is even more important during more challenging stock environments, such as during times of inflation or recession. Some potential options for investing in stocks are as follows:

  • Domestic stocks: A well-diversified portfolio should be able to insulate parts of the portfolio even if some parts are impacted by inflation. Adjustments to portfolio holdings and sector weightings may also help to insulate your portfolio from inflation. Dividend stocks, consumer staples companies that are more able to pass on higher costs, and real estate investment trusts (REITS) are all possible options to consider. 
  • International stocks: Exposure to international stocks is another way to diversify a portfolio, and exposure to stocks in nations with lower inflation rates is another way to hedge against domestic inflation.
  • Dividend stocks: A stock that pays dividends provides income that can help hedge against inflation. In addition to the stock’s performance, the dividend income can be reinvested. 
  • Mutual funds and ETFs: Mutual funds and ETFs are an easy way to obtain access to a diverse portfolio of stocks, and there are mutual funds and ETFs that can help protect against inflation. 

5: Buy Alternative Investments 

There are other options available for hedging against inflation. Some of these options include other assets that produce income, rise during periods of high inflation, or are not correlated to inflation. Some of them include the following: 

  • Real estate: Real estate often produces income for its investors in addition to the possibility of asset appreciation. Further, rents can often be raised in conjunction with rising prices during inflationary times.
  • Commodities: The prices for raw goods, such as commodities, helps fuel inflation. Why not gain direct exposure to commodities, since they are likely to increase in price? This can be done by direct investment; investment in companies that have exposure, such as commodities processors; or funds that focus on commodities. 
  • CDs: Similar to high-yield savings accounts, certificates of deposit (CDs) may provide higher interest rates than traditional savings vehicles. Similar to bonds, the longer the maturity of a CD, the more risk of purchasing power loss there is from rising rates often caused by inflation.
  • Cryptocurrencies: If the U.S. dollar is losing purchasing power to inflation, cryptocurrencies may be a viable hedge because they are seen as a hedge against U.S. dollar weakness.   

Best Alternative Investment Platforms

Platform Focus Minimum Investment 
Fundrise Real estate investments $10
Masterworks Art investments $10,000
Yieldstreet Asset variety $2,500
iTrustCapital Gold and cryptocurrency $1,000

FAQs

What Investments Do Well During Inflationary Periods?

Some investments that have historically performed well during inflationary periods include gold, commodities, real estate, and consumer-focused stocks that are able to pass on prices to consumers. Treasury Inflation-Protected Securities (TIPS), designed to compensate investors for the impact of inflation, have also become popular investments when there is inflation.

What Is the Most Common Hedge Against Inflation?

The most common asset classes for protection against inflation include gold, commodities, a balanced and diversified portfolio with a 60/40 split between stocks and fixed income, real estate investment trusts (REITs), rental income from real estate, the S&P 500, and TIPS.

How Much Cash Should You Keep During Inflation?

The general rule of thumb is to keep cash, or cash equivalents, available to cover between three and six months of expenses. Unfortunately, inflation typically reduces the buying power of cash, so it is important for people to have their cash in a cash equivalent vehicle that reduces this negative impact of inflation by providing a reasonable rate of return; these returns will usually take the form of interest rates. Cash and cash equivalents (CCE) are vehicles that provide maximum liquidity, and include non-interest-bearing assets such as actual dollar bills, coins, and other foreign currency, as well as other very liquid investments with maturities of three months or less that can easily be converted into cash. These include Treasury bills (T-Bills), other short term government paper, bankers acceptances (BAs), commercial paper, certificates of deposit (CDs), money market accounts, checking accounts, and savings accounts

Other marketable securities, such as stocks and longer-term fixed-income securities that are very liquid, are often held as cash on corporate balance sheets, but these investments can be more volatile than the cash equivalents just outlined, so are less appropriate as a substitute for cash for individuals during periods of high inflation.

How Can You Hedge Against Inflation During Retirement?

Hedging your portfolio and wealth for inflation remains important during retirement. Retirees and those closer to retirement need to think about their overall expenses, and how inflation will impact those expenses over time, because a 5% return with 2% inflation is better than a 10% return with 8% inflation. The best ways to hedge for inflation remain some of the best wealth management techniques, namely, to have a well-diversified portfolio. In addition, you may want to make some changes to your portfolio so you are over-weighted towards assets that have historically performed better during times of inflationary pressure. This includes gold, commodities, and income-generating real estate assets. In addition, companies that make the consumer staples people still need will typically do better than other stocks because these companies are better able to pass on their increased costs to their customers. 

Since fixed-income holdings are often a larger part of retiree portfolios, another important strategy for hedging during inflation is to adjust the duration of your fixed-income holdings. The longer out the maturity of a fixed-income holding is, the more volatile the price of that holding becomes. Since interest rates often rise during inflationary periods, longer dated fixed-income holdings are likely to lose value faster than those that are longer term. Further, shorter-dated fixed-income holdings can be reinvested at higher rates as they mature, which provides another advantage to shorter-term fixed-income securities as rates move higher. TIPS are another helpful fixed-income vehicle for hedging inflation.