Morningstar.com readers comment about the inflationary threat and best investments to hedge against it.
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By Christine Benz | 07-24-11 | 06:00 AM | Email Article

Inflation is one of the natural enemies of most investors: Think of it as compounding in reverse: What your investment returns give with one hand, inflation can take away with the other.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

Mercifully, given all of the other worries investors have had to contend with during the past decade, inflation has been relatively tame. But most Morningstar.com users who posted in response to my recent query in Morningstar.com's Portfolio Design/Management forum don't think the benign inflationary environment will last. Many posters noted that they're expecting inflation in line with historic norms, if not higher, and they've implemented portfolio hedges in an effort to offset its ravages. To read the complete thread, or add a comment of your own, click here.

Expecting at Least Moderate Inflation
Many posters were quick to (rightly) point out that predicting inflation is something of a fool's errand: Like trying to guess the direction of the market or currencies, pinning down the inflation rate requires you to get your arms around myriad impossible-to-predict forces, including the rate of economic growth both here in the United States and overseas.

Philippi noted that not only can it be difficult (or impossible) to forecast inflation, but it can also be hard to predict how various investment instruments will react when prices are on the move. "I try not to let my expectations and assumptions influence my portfolio. I don't forecast very well, and from what I've seen neither do many professionals, either. All the assets react differently and perhaps beneficially to rising inflation except for longer-term fixed income, so it is difficult to identify which ones are here for inflation reasons."

Darwinian gave it to us straight: "It is, of course, impossible to accurately predict inflation, or anything else in the financial realm."

Mesmer quipped, "I have no inflation expectations, since I misplaced my crystal ball a long time ago."

Mwleach, too, acknowledged the difficulty of predicting inflation, but went on to note that factoring in at least a modest rate of inflation is reasonable for portfolio-planning purposes. "According to Ibbotson, inflation has averaged just below 3% per year for the past 84 years. It might be reasonable to assume that we will face around 3% going forward for the next 85 years. The devil is in the details, however. A lot can happen between here and there. The lowest 10-year average we've seen for inflation (U.S.) was from 1926 to 1935--minus 2.6% per year annualized. The highest 10-year average was from 1973 to 1982--plus 8.7% per year annualized. Quite a difference for planning purposes. Given our current economic conditions, I would think that a modest rate of inflation--slightly below the long-term 3% average rather than slightly above it--is most likely during the next decade.

"However, there is one major caveat to my assumption. The temptation to debase a nation's currency in hard times has been a strong and pervasive one throughout history; it is one that I think will be difficult for our current policymakers to resist. In extremis this could lead us to substantial inflation--even hyperinflation. The chances of this happening are low in my opinion, but they are definitely above zero."

FidlStix also thinks moderate inflation--in line with historic norms--over the long term is likely. "In the near term, the next few months, I expect inflation to moderate a bit as commodity prices generally settle. However, in the longer view (several years), inflation has nowhere to go but up. The Federal Reserve can't hold the lid on interest rates forever (can they?). Aside from macroeconomic considerations, I'd expect inflation to climb simply because of reversion to the long-term mean of about 3%."

Poster TMTango is using a long-term inflation rate of 4%--slightly above the historical inflation rates that mwleach cited--as a baseline for long-term portfolio-planning purposes. But he wouldn't be surprised if short-term inflation rates are even higher. "Our long-term financial-planning spreadsheet is based on a growth factor of 6% and an inflation factor of 4%. I think that the long-term projection of inflation at 4% is reasonable, at least given historical measures. I consider the short-term threat of inflation to be a more serious matter, but then at age 70, I am a product of the post-Vietnam experience and recall all too well the inflation and interest rates of the early 1980s when I wasn't able to refinance a house and lost it. However, I don't have the ability to project a number for what I think inflation during the next five to 10 years might look like."

jkimel44, meanwhile, opined that the inflation measures the government uses might not match consumers' experiences. "Are we talking about real inflation, or the government Consumer Price Index? I suspect it is the latter, which has shown essentially no inflation during the past few years due to the heavy influence of housing prices. (Real inflation, for those of us who are retired or working hard just to meet expenses, is easily running at 5%). The government is delighted with the housing-heavy method of calculating inflation, since it means no increases in Social Security payments." He went on, "My prediction for the CPI is a less than 1% increase in 2012; 2% in 2013, and 3% in 2014. My prediction for real inflation is 3%-5% per year for the next three years."

Capecod, always a well-informed voice worth listening to, was the lone dissenter among posters who believe inflation will be mild or worse. He wrote, "I am somewhat less enthusiastic about the course of inflation than the Fed. Specifically, I believe that after peaking in August or September, both core and headline CPI will trend down rapidly, setting off another deflation scare by early 2012." (For more details on the difference between core and headline inflation, check out my colleague Esther Pak's recent article.)

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