US TIPS vs Gold, Part 1: Understanding Inflation Is The First Step In Hedging It
(5 min read)
The possibility of rising inflation on the horizon means investors should consider their hedging options. In this piece, we weigh up US TIPS vs gold alongside a detailed breakdown of CPI.
The long-term downtrend in US core CPI appears to have stalled, although it remains below the Fed’s 2% target level. Moreover, the Fed recently announced that it now believes that targeting an average inflation rate of 2% is preferable to holding it near that level, implying that a deliberate overshooting may reverse the undershooting of recent years. In this context, investors should consider how best to position for a persistent (if perhaps only moderate) rise in CPI in the next few years.
Two obvious inflation hedges are US TIPS, linked directly to US CPI, and gold. The former is indeed an effective hedge against headline CPI. However, for some investors, CPI may not be the most applicable benchmark for hedging against the real cost of living given that consumption baskets tend to shift, especially over longer periods of time. There are also non-inflation risks to consider, particularly for international investors. In such cases, gold is probably the better option versus TIPS.
What is inflation? Prior to the 1930s, when economists discussed inflation, they normally meant increases in the money supply rather than the price level. The assumption, however, was that changes in the money supply would impact consumer prices in some way, if not necessarily 1:1, as per the venerable Quantity Theory of Money, normally written as MV = PQ, in which:
- M is the quantity of money
- V is the ‘velocity’ of money, that is, the rate at which money circulates
- P is the price level
- Q is the level of real economic output
While Milton Friedman and the Chicago School revived interest in the Quantity Theory during the 1950s and 60s, it received its most famous use as an active instrument of monetary policy in the early 1980s, when Fed chairman Paul Volcker reoriented US monetary policy around explicit monetary targeting. However, the point of money targeting was to bring down the rate of CPI inflation, which was running in the double-digits at the time.
Today, when economists talk about inflation, it is nearly always assumed that they mean the price level, which in the US is normally either the CPI or the deflator for personal consumption and expenditures (PCE) as estimated within the national GDP accounts.
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