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With the Federal Reserve engaged in heavily expansionist policies, investors in the USA have been wary about impending inflation and a corresponding reduction in the standard of living.

The Federal Reserve is committed to buying $85B in Treasuries and Mortgage Backed Securities until unemployment comes down to 6.5% from the current 7.9%. It is willing to let inflation rise to 2.5% in the process. This, many believe, will cause hyperinflation in the U.S. Dollar.

While the rumors of hyperinflation are greatly exaggerated, there is reason to believe that inflation will rise moderately in the long run in the USA. In fact, that will be a great thing for the U.S. economy. Rising inflation expectation cause people to spend more today, rather than waiting for prices to drop tomorrow and then buy. This causes increased economic growth from higher demand.

For now hyperinflation, or even inflation, remains moderate as the velocity of money has dropped in the USA as consumers deleverage their individual balance sheets. For more details please see my article on Hyperinflation. However, increasing money supply has caused hyperinflation several other countries.

Argentina, for example went through a severe bout of hyperinflation in the 1980s and the 1990s, when vendors were raising prices hourly in order to keep up. Reports Wikipedia:

Argentina went through steady inflation from 1975 to 1991. At the beginning of 1975, the highest denomination was 1,000 pesos. In late 1976, the highest denomination was 5,000 pesos. In early 1979, the highest denomination was 10,000 pesos. By the end of 1981, the highest denomination was 1,000,000 pesos. In the 1983 currency reform, 1 peso argentino was exchanged for 10,000 pesos. In the 1985 currency reform, 1 austral was exchanged for 1,000 pesos argentinos. In the 1992 currency reform, 1 new peso was exchanged for 10,000 australes. The overall impact of hyperinflation: 1 (1992) peso = 100,000,000,000 pre-1983 pesos.

Start and End Date: May 1989- Mar. 1990Peak Month and Rate of Inflation: Mar. 1990, 197%

In Zimbabwe, hyperinflation completely destroyed the value of the currency, such that today Zimbabwe has no independent currency, it used foreign currencies instead. Incidentally, inflation was at 6.5 sextillion percent in Zimbabwe when the local currency was dissolved. To put things into perspective, one sextillion equals 1021 - that's 21 zeroes! The currency ended up worthless.

I believe such levels of hyperinflation will never happen in the USA. The U.S. dollar is too important or the global economy and faith in the dollar will remain as long as there are no other currencies. The two currencies that can be potential rivals for the dollar in terms of size and liquidity are the yen and the euro, and both are under severe pressure now. Still, U.S. investors are right in wanting to preserve their wealth in the event some inflation arrives on the shores of the USA.

I decided to do some research on what has historically been the best inflation hedge for U.S. investors. The most popular hedge has been gold. Gold, as we all know, was once used as currency throughout the globe. Even when modern day currencies came into being, they were backed by gold. These days gold backed currencies are a thing of the past, but there remains a strong movement to hold gold as a hedge against profligate government policies and money printing. With that in mind, I decided to see how gold has done as an inflation hedge.

Consumer price index is the common measure of inflation in the USA. It measures how the prices of a basket of goods and services has changed value over a period of time. I decided to compare the returns for gold, the inflation in the Consumer Price Index, and the returns for the S&P500 (NYSEARCA:SPY) over the last 60+ years. The below table shows how the three changed.

1950

2013

Inflation

S&P500

17

1518

7.4%

Gold

35

1606

6.3%

CPI

24

229

3.6%

As the table shows, CPI in 1950 was at 24, while in 2013 it is at 229. This is indexed to 1982 prices at 100. So, on average we have had 3.6% price inflation in the USA every year. Gold (NYSEARCA:GLD) in 1950 was at $35/oz, and today it is at $1606/oz. Hence, gold has yielded about 6.3% every year, which is very impressive. Someone who wanted to preserve their wealth and put it all in gold in 1950 would have received a return of 2.6% every year, adjusted for inflation. Over 63 years, this is an impressive 5x real growth in wealth.

Out of curiosity, I checked how this investor would have done if (s)he put all her wealth in the S&500 instead. The S&P500 was a brand new index in 1950 and debuted at (split-adjusted) $16.66. Today it is at $1518. This means an average annual return of 7.4% per year, or 3.7% adjusted for inflation. Over 63 years, this means a 10x real growth in wealth.

Given the above numbers, I am inclined to conclude that investing in a broad market index such as the S&P500 is a far better hedge against inflation than gold. It in fact grows real wealth at a far more impressive rate. However, prices have been volatile for the S&P500 over its lifetime. Hence, perhaps 10% in the investment portfolio for S&P500 as an inflation hedge is about right for the average investor.

Currently, I am extremely bullish on the U.S. market because of the excess liquidity being injected by the Federal Reserve. A whole host of statistics that came out this week indicate that the U.S. economy is on the mend. Initial jobless claims were down more than expected, consumer sentiment was up more than expected, and manufacturing numbers were far better than expected as well. Given that, I have decided to put 105 of my portfolio in the 3x leveraged ETF on the S&P500 (NYSEARCA:UPRO). It is up handsomely by about 25% this year, and I believe that there is another 50% left by year end. (As to why, please read my article on my S&P500 year-end forecast.)

That would be a very nice inflation hedge for several years indeed.

Disclaimer: This is not meant as investment advice. I do not have a crystal ball. I only have opinions, free at that. Before investing in any of the above-mentioned securities, investors should do their own research, consult their financial advisors, and make their own choices.

Source: How To Protect Your Wealth From Inflation