How to stop worrying and learn to love inflation

Reader Dom D. from San Antonio wrote this to me recently: “Given the staggering debt of the United States and Congress’ seemingly laissez faire attitude and impotence towards addressing it, I am starting to be concerned about the value of U.S. currency. Historically, wars and corrupt governments have led to hyperinflation in other countries where the costs of goods and services skyrocket. The likelihood of this happening in the U.S. may seem remote but it is not impossible. Are there ways for individuals to protect themselves from this?”

I really like this question. Dom recognizes our unprecedented debt situation and the unfortunate parallels with other countries where hyperinflation followed. I have no idea what’s going to happen.

Hyperinflation would require a failure by the Federal Reserve to do its job, and the Fed has withstood the last few years better than most institutions. But, yeah, increased inflation seems increasingly likely for the reasons Dom named. So what to do?

Something to remember about inflation is that if the underlying economy is unchanged but the amount of available currency doubles, it is reasonable to assume that the price of things approximately doubles. This is bad when we have to pay for things. It is not necessarily bad if the price of things we already own doubles. Things you could own, which should double in price if the supply of money doubles, include real estate and stocks. As a result, these make for very good inflation hedges.

So the first great way to hedge against inflation is to own a business, or preferably many businesses. Some insist on the hard way to do this. I would like to focus everyone’s attention on the lazy way — my preferred way— which is to own hundreds or even thousands of businesses through a single, low-cost, diversified stock mutual fund.

In an inflationary environment, successful businesses raise prices in response to their higher costs. Successful businesses adjust dynamically to earn profits despite inflation.

Similarly, it is reasonable to expect, all else being equal, that a stock worth $100 today will be worth $200 tomorrow if the amount of currency doubles overnight. One explanation for the record rise of the stock market in the past few months — the one I find most plausible — is that the Fed has dramatically increased the supply of currency in the economy. The record stock market rise is probably a specific form of inflation hitting one very visible corner of the overall economy.

The second great hedge against inflation is to own real estate in advance of inflation. For starters, try to own your home. And then live in it for a long time. The price of your home should appreciate roughly at the rate of inflation. That’s the definition of a good hedge.

Let’s say, for example, you own a home today worth $250,000. And then we suffer a patch of 10 percent annual inflation for 10 years. Your house at the end of 10 years will be worth a little over $648,000. Compound interest math uses the same formula as inflation math.

Now, here’s an even more interesting twist on inflation hedging via homeownership. The triple lindy inflation hedge, if you will. Are you ready for it?

Do you have a long-term, fixed-rate (let’s say, 30-year) mortgage on your house?

Ta-da! You did it. You are amazing. Have you ever thought about being a hedge fund manager?

Here’s why this is an amazing inflation-hedging tool. Using the previous example, as your home value leaps upward over 10 years of 10 percent annual inflation from $250,000 to $648,000, your 30-year fixed-rate mortgage decreases dramatically, both in

nominal and real terms. Using a standard 30-year amortization schedule, your mortgage would pay down from $200,000 to $162,000 during the first 10 years.

At the end of 10 years, a $162,000 amount of debt on a house worth $648,000 is actually pretty easy to handle. You moved from owning $50,000 in home equity to $486,000 in home equity, an increase of nearly 10 times.

Also, just as money isn’t worth as much following inflation, debts are also not worth as much in an inflationary future, so

$162,000 in debt is not as big a deal in that future as it would be today. In other words, being a borrower during an inflationary period is actually a powerful inflation hedge. (Provided, of course, your debt has a fixed, rather than variable, interest rate.)

By owning your home, you’re a fancy inflation hedger, and you didn’t even know it.

Next, what should you specifically not do if you anticipate future bouts of inflation?

Do not buy fixed-income products for any investment purposes. These include bonds, bond funds, annuities and certificates of deposit. Inflation absolutely wrecks the value of these fixed-income investments. Even money market funds, savings accounts and cash could be considered fixed income, just with an extremely short (same day) maturity date. If your net worth or income is in any of these fixed-income products, inflation will destroy your wealth.

Next, do not buy gold as an inflation hedge. Gold is a pretty but useless metal sold by those preying on the fears of unsophisticated financial minds. I understand you don’t believe me, because of all those plausible sales pitches on your video screens, but it’s true.

Also, do not buy bitcoin as an inflation hedge. Bitcoin is a fake currency, neither useful for buying beer nor paying taxes. It has no legal use case and produces no wealth, except for people hyping you to buy it.

In sum, own your own home, own some businesses either directly or through the stock market, and if you must borrow, do it at a fixed interest rate. Avoid the standard inflation-hedge scams.

What I really like about the previous two sentences is that in anticipation of heavy inflation — and I cannot emphasize this strongly enough — you should pursue exactly the same investment actions I would advise to someone who is not anticipating a future bout of heavy inflation.

Did you catch that? It’s important. Do exactly the same prudent things you should always do.

Finally, is Dom’s scenario likely to come to pass? I don’t know. No one does. Pundits who predict the economic future with certainty are fools or confidence men to be deeply distrusted.

I have personally (but silently) expected significant inflation since aggressive interest rate drops in September 2001. I’ve been consistently wrong.

Although, maybe not. Come to think of it, my home value and my stock index funds have suffered quite a bit of inflation over the past 20 years. Haven’t yours?

Vernon Bryant / Dallas Morning News Homeownership, with a fixed-rate 30-year mortgage, is one of the best hedges against hyperinflation.