Five Ways to Keep Inflation at Bay

Reassurances from the Fed aren't helping consumers' stretch their paychecks any further, but here are some ways to hedge your investments against inflation

by David Bogoslaw

In a speech at an economic research conference on July 10, Federal Reserve Chairman Ben Bernanke seemed fairly optimistic about inflation but said that inflation expectations remain "imperfectly anchored." Unlike 30 years ago, inflation is much less sensitive to things like the persistent spikes in energy prices seen in recent years, the Fed chief said.

So why is that most people feel their salaries aren't buying as much as they did before and that their standard of living is slipping?

So-called core measures of inflation, which exclude volatile food and energy prices, have given some favorable signals on prices recently. But the pinch in their purses that most consumers are feeling from higher gasoline, home heating fuel, and food prices has many of them questioning whether economists have it wrong in saying inflation no longer poses a serious threat.

Wages Aren't Making It

In earlier days, one way people used to hedge inflation was to demand a raise from their bosses. The nonfarm payrolls report released July 6 showed hourly wages were up 3.9% over last 12 months, very little compared with the 2.7% rise in overall inflation year-over-year as of May, says Carl Tannenbaum, chief economist at LaSalle Bank in Chicago. "That's not really much of an increase in most people's living standards. There are a number of reasons labor hasn't had that leverage—the availability of offshoring, production efficiencies that have given managers more control."

The disappearance of wage leverage has given greater urgency for many people to combat inflation another way —through their investment portfolios. The increasing popularity of inflation-protected Treasury bonds, which locks in a real return rate, attests to investors' thirst for relief. The government has been issuing the inflation-adjusted Treasury bonds in ever greater numbers, as have private issuers such as banks, so supply has risen to meet the demand.

And that's just for starters. This week, Five for the Money explores ways that investors can protect their portfolios from the harmful effects of inflation.

1. Treasury Inflation-Protected Securities

Rising inflation is especially harmful to investors in fixed-income securities, as the purchasing power of a bond's principal amount, usually $1,000, is lower at maturity when interest rates are higher than the bond's yield.

Treasury Inflation-Protected Securities, or TIPS, were created in 1997 to enable investors to avoid having the real returns on their bonds eroded by rising inflation and interest-rate levels. The coupon on the bonds is fixed, but investors get an extra kick: The principal amount on TIPS is increased periodically to keep pace with changes in the Consumer Price Index, or CPI. Its interest payment is calculated on the inflated principal, which is eventually repaid at maturity. The yield to maturity on the the 10-year TIPS is 2.71%.

Investors decide whether or not to buy TIPS based on the difference in the yield to maturity they offer and the similar yield on a conventional Treasury bond, which is now at 5.08%. Investors who believe that over the next 10 years inflation will average more than 237 basis points, or 2.37%, should buy TIPS, while those who think inflation will be less than 2.37% should stick with conventional Treasury bonds.

"[TIPS'] break-even rates give investors a way to judge whether they're being fairly compensated in an inflation-linked security vs. a conventional fixed-income security," says Mike Brandes, senior fixed-income strategist at Smith Barney. Even if you don't have a strong conviction about inflation, TIPS are a good way to diversify your bond portfolio to hedge against potential inflation pressures, he adds.

TIPS are subject to federal taxes but are exempt from taxes on the state level.