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The following is excerpted from my monthly newsletter.

Recently, it has been quite hard not to worry about inflation. Gas prices and many other commodity prices have risen rapidly over the past couple of months while the dollar has dropped. In addition, the spread between treasuries and inflation-indexed treasuries has increased sharply implying a higher amount of inflation. However, it is far from a sure thing that inflation has taken hold again; real estate prices are still declining.

Inflation is driven by supply and demand of the money (dollars). Many commentators only look at the supply side of the equation. The supply is often, but not always, enough to determine the longer term trend of the purchasing power of the dollar. In the short term, demand often has large effects. For example, in the summer of 2008 many thought the dollar would continue to decline because of the supply of dollars. However, they overlooked the demand for dollars. The demand for dollars increased due to deleveraging.

In the longer term, the supply of money has increased with the bailouts and economic stimulus. The large increase in supply did not have immediate effects because demand had increased. However, when demand declines inflation will increase unless the money supply is reduced.

So while in the long term there is likely to be inflation, in the short term, deflation is still a realistic possibility. Even with the short term possibility of deflation, investing part of your assets in securities that benefit from inflation will probably pay off if held long enough. The easiest way to protect a portfolio from inflation is to buy several ETFs or mutual funds that invest in several types of assets that will benefit from inflation. Below are a few of them.

Gold

Gold is a classic inflation hedge. It is not a business and does not have earnings so it is more of a speculative play on inflation. The well known SPDR Gold ETF (GLD) is the largest ETF, but iShares COMEX Gold Trust (IAU) and PowerShares DB Gold Fund (DGL) are also fine. PowerShares DB Precious Metals Fund (DBP) is a more diversified approach and includes silver as well.

Commodities

Commodities, like gold, are also speculative. They will not benefit unless there is inflation. PIMCO CommodityRealReturn Strat CL D (PCRDX) and IPath Dow-Jones AIG Commodity Index Total Return ETN (DJP) are broad diversified options for investing in commodities. I would not use the iShares S&P GSCI Commodity Indexed Trust (GSG) because it is heavy on energy. PowerShares DB Commodity Index Tracking Fund (DBC), while not very diversified, may actually be the best long term investment in commodities because of the strategy it uses to roll the futures. However, it may have greater day-to-day volatility as it only holds six commodities and is about 50% energy.

TIPS

Unlike commodities TIPS earn income and are one of the safest ways to protect against inflation. There are multiple TIPS Mutual Funds (VIPSX, FINPX, PRRDX) and at least two ETFs (TIP, IPE).

Real Estate

The profits of a company that deals with real estate or owns real estate have a lot to do with real estate prices. Currently real estate prices have been dropping, but if inflation takes hold real estate prices could turn around and start rising. REITs can also provide a large dividend.

Hard Asset Companies

Like real estate companies, the profits of hard asset companies closely relate to the prices of the commodities the company produces. Energy, materials, and many other subsectors fit into this category. Market Vectors Hard Asset Producers (HAP) unlike other natural resource ETFs is diversified more evenly across industries and is probably the easiest way to gain exposure to this sector.

MLPs

MLPs like REITs must payout a certain part of their profits as dividends. They are usually engaged in energy or real estate businesses and so have some inflation protection. The easiest way to invest in MLPs is to own a CEF that invests in them such as Kayne Anderson MLP (KYN) or Fiduciary/Claymore MLP Opportunity Fund (FMO).

Foreign Bonds

Foreign bonds are a good way to protect against a decline in the dollar. PIMCO Foreign Bond CL D (Unhedged) (PFBDX) and Merk Hard Currency (MERKX) both provide unhedged exposure to foreign bonds. Alternatively, with ETFs there is SPDR Barclays Capital Short Term International Treasury Bond ETF (BWZ) and S&P/Citigroup 1-3 Year International Treasury Bond Fund (ISHG) for short-term international bonds and S&P/Citigroup International Treasury Bond Fund (IGOV) and SPDR Barclays Capital International Treasury Bond ETF (BWX) for intermediate term bonds. One unique international bond ETF is SPDR DB International Government Inflation-Protected Bond ETF (WIP). With this ETF you can gain exposure to foreign currencies at the same time as protecting those foreign currencies from inflation.

These are all good assets to invest in to protect against inflation, however, to protect against the possibility of increased deflation in the near term, cash is probably the best option.

Normally, I would include long-term treasury bonds as an investment that benefits from inflation but there is currently considerable long-term downside risk. However, if the government finances the bailouts and economic stimulus by issuing bonds, then it may oversupply the treasury market with new debt, causing prices to decline substantially.

Disclosure: Long DJP, DBP

Source: Profiting from Inflation: 7 Investment Ideas