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These days, inflationary and deflationary forces are battling it out. While there is pretty massive uncertainty in the short run, I think that in the medium to long term the odds favor inflation. This is because inflationary policies are technically and politically easy to implement but technically and politically very difficult to unwind.

Inflation affects different people differently. You can think of it as a wealth transfer from creditors to debtors. Creditors are long cash, so they lend it out. Debtors are short cash so they borrow it. During inflation the value of cash goes down harming those who are long it (creditors) and helping those who are short it (debtors.)

Most people are some combination of debtor and creditor. Most people have some debt, whether it's a mortgage or a student loan or a credit card, but most people also have some savings whether in a bank account or a 401k. Anyone with savings needs to be thinking about ways to protect themselves against inflation.

Traditional hedges for inflation are real assets: real estate, commodities, or precious metals. The current state of the economy and the nature of the crisis make them less useful this time around.

Real Estate:

Real estate is an inflation hedge because it is a real asset. As the value of the dollar falls it takes more of them to buy the same house so the price should go up. If financed with a mortgage this is even better because the mortgage principal does not increase but it's real value declines as the currency weakens. So if you already have a house with a mortgage on it, don’t be in a hurry to pay it off; this is an excellent inflation hedge. If you don’t own a house you could get exposure to real estate in your investment portfolio through REITs.

That said, if you are looking to protect your savings against inflation, buying more real estate right now is probably not a good idea. It’s no secret that one of the reasons for the crisis we are in now is that real estate prices became an asset bubble which is now deflating. Thus, though inflationary pressures should drive up house prices, the fact that we are coming off of a bubble and the correction seems to have further to run makes real estate a difficult choice as a pure inflation hedge.

Commodities:

Commodities are also real assets and also performed admirably during the 1970s. Today there are many easy ways to take get exposure to commodities with the advent of ETFs. DBA, USO, or UNG all allow a retail investor to get access to commodity price movements.

As with real estate, however some caution is warranted. In addition to their being inversely correlated with the dollar, commodities are also directly correlated to the level of economic activity in the world. Specifically, in the past few years commodities have been driven by the substantial increase in the scale of world trade because China is a very large importer of commodities. These days, at the same time as the contraction in GDP, there is also a contraction in the scale of world trade. This means that if the economy gets worse before it gets better then commodity prices could still fall precipitously with economic activity and declining trade volumes, making them a less effective hedge against inflation.

Precious Metals:

Precious metals are a pure hedge against monetary devaluation because they are a substitute for currency but have a fixed supply. Precious metals are also easy to trade through ETFs such as GLD, a share of which represents about a tenth of an ounce of gold; so if gold is at $885 an ounce, GLD is about $88.5.

Precious metals have not participated in an asset bubble like housing nor are they correlated as closely with world economic output and trade-like industrial commodities. The problem is timing. If the TARP and the TALF don’t work or the stress tests show that the balance sheets of the banks are worse than the market thinks, then there could be a further contraction and short term disinflation or deflation.

So if you simply went out and bought precious metals and then the economy took a turn for the worse you would be looking at losses on your gold, but not necessarily a gain in the savings you were trying to protect. This isn’t too helpful either.

So what does this mean? Is it hopeless? Not at all, but the solution is a little complicated.

Use all your options, including options.

What if I offered to make the following deal with you? In 2011 we would look at the price of gold. If, at that time the price of gold was above $1250/oz I would sell you gold for $1250/oz and if gold was below $750 you would have to buy it from me at $750? If the price of gold was between $750 and $1250 that is, neither inflation nor deflation occurred, we would do nothing.

Sounds like a good deal, doesn’t it? You only want to own gold if there is inflation and the price of gold goes up a lot. If it does you get to buy it from me for $1250 no matter where it is. If we have deflation and the price of gold goes down below $750 then you have to buy it from me for $750. That’s not great but it is a lot better than buying it today at $885 an ounce where it is today. Keep in mind that we only transact if either inflation or deflation, as evidenced by the price of gold, has actually occurred. Sounds like an ideal hedge for an uncertain future.

So how do we accomplish this agreement? We use the option markets. What you want to do is buy a January 2011 $125 call on GLD which gives you the right to buy a share of GLD for $125 at any time between now and January 2011. At the same time, you want to sell a January 2011 $75 put which obligates you to buy GLD for $75 anytime between now and January of 2011. You’ll notice that these options are roughly the same price so what are you really doing is selling the put, taking the cash and buying the call. If the prices are not exactly the same they won’t be off by much. Let’s say that the call is $6 and the put is $7, then you take in an extra dollar if nothing happens or if you wind up buying the GLD, you’ll effectively do it at $74 or $124 which is a little better for you anyway.

Another nice thing about this trade is that you already know what is going to happen if gold goes to $750. If gold goes below $750, despite the fact that the government has announced all the plans it has to print money, you know what they will do next: print more money. This strategy which Ben Bernanke announced all the way back in his famous “helicopter money” speech back in 2002 will, sooner or later, raise the price level and with it gold. So in a lot of ways Ben Bernanke has already sold you the put that you are selling to finance your inflation hedge. Thanks, Uncle Ben.

Disclosure: Long USO

Source: Inflation Defense: Traditional Methods Shaky, But There Are Options