Hedging against inflation: gold or I bonds?

Tom, I’ve heard some people expressing the concern that the CPI (by which I bond rates are determined)is actually not a very good measure of inflation and the government is underreporting true inflation. Do you know if there is any truth to that? How can we measure how good the CPI holds up vs. “true” inflation and what determines true inflation anyway? Does it even matter how true the CPI is, as long as everyone uses it as a benchmark for their investments?

Mario – economists take a wide variety of positions on how to measure inflation or even whether inflation can be measured, so there are no certain answers here.

If you’ve been using I bonds to save up for a house the last few years, clearly the price of houses has gone up a lot faster than the Consumer Price Index and you would have clear evidence that the CPI is underreporting the prices you’re interested in.

Interestingly, because houses are something you own rather than consume, the price of houses isn’t even considered in coming up with the CPI, although the cost of rent is. But rent has gone up just slightly while the price of houses has gone up dramatically.

On the other side of the balance, there’s a group of people who complain the CPI overreports the true inflation rate. Their argument basically says that if the price of gas goes up, you can always buy a car that uses less gas. The proportion of your budget that you spend on gas would stay the same, they say, thus there’s no inflation.

The counter-argument to this position is that taken to its logical extreme we’re all living in cardboard houses and eating gravel while the economists are saying nothing important happened.

At the end of the day the CPI is the best measure of inflation we have and it’s what the Treasury uses to set the I bond rate. If it doesn’t measure the kind of inflation you’re interested in, I bonds won’t protect you from that kind of inflation.

I can see it now, the “H-I Bond of 2010”, whose interest will fluctuate according to some new housing-inflation index…

I think you were a little hard on us gold holders.

I’ve had physical gold as part of my total portfolio since 1994. I’ve seen it go down, I’ve seen it go up, and I’m happy whichever way it moves next. I’m not interested in trying to “time the market” and sell at a peak, I’m interested in holding for the long term.

For me, gold is a key part of being diversified. Gold is not correlated to most other investment types, so it tends to offset moves in other parts of the economy. Gold has flaws; it produces no income and generates no interest.

For me, gold is a hedge against US Government default, international economic disruption, and certain forms of inflation.

Now, I also hold I-Bonds. As you’ve well explained on your site, they too have a unique purpose. I-Bonds provide a good hedge against inflation and rising rates, a hedge that is otherwise hard to find in the traditional equity and bond markets. But I-bonds carry a risk. The US government has defaulted on financial instruments in the past and could do so again. The CPI metric which I-bond rates is based on is subject to political manipulation.

In my total portfolio I try to maximize gain and hedge risks. My I-bonds represent my “emergency cash”, 3-4 months of living expenses that I could tap into if needed. My gold represents my “last ditch” fund, only to be sold if I have no other option, or if portfolio rebalancing dictates it.

My total portfolio includes the above, plus US stocks, european stocks, pacific stocks, emerging market stocks, money market accounts, inflation indexed bond funds, and traditional bond funds. And I generally sleep well at night, not concerned by the daily fluctuations in precious metals.

NoSchmuck – Sometimes the words I choose for emphasis go too far, but in this case I wasn’t calling those who hold gold schmucks – I was saying we all tend to feel like schmucks when the value of one of our investments goes down.

And when I said “gold is no safe haven” I meant at today’s prices. In 1994 the price of gold was much lower than it is now.

Your investment diversification strategy looks good to me. You don’t say so, but I assume you hold physical gold in your possession, which has its own risks. If our society breaks down to the point where the government isn’t honoring its debts, there’s little reason to believe brokerage firms will be able to honor theirs, either, so holding gold stocks or any kind of paper or electronic gold wouldn’t have the safety you’re looking for.

I appreciate your comment. It adds another perspective and the best investment strategy – diversification – requires a lot of perspectives.

Hi Tom,

Maybe I was overly sensitive – I apologize if so.

You are correct, my holdings are physical. This does of course present additional risks not present in other investment types: theft, fire, disaster.

In the grand scheme of things I’m happy; this diversification of investments automatically creates a diversification of risks.

I’m not one of those types who is expecting a complete and utter breakdown of society. I believe it is possible (but unlikely) that I could have to shepherd my family through some localized disaster where some things may speak more loudly than greenbacks.

As far as government notes go, I don’t fear that they will ever be completely repudiated. What I do fear, especially given the nature of our politicians, is that the terms of the agreement would be changed on us.

A case I keep in mind – once upon a time a gold certificate was a sovereign promise by the US government to provide gold in exchange on demand. That promise was broken, the terms were modified, and now all you can trade a gold certificate for is a federal reserve note of equal face value. Not really the deal that was originally made.

So, what happens if due to a crisis, the government decides that it will temporarily limit the redemption of bonds? What if they put a weekly or monthly cap on withdrawals?

I don’t want to be paranoid, I just want to sleep easy. And I do so by convincing myself I’ve covered as many bases as I can.

Once upon a time I slept easy while being 100% in equities. I was younger and more foolish then.

Cheers!

Gold is a highly volatile hedge against inflation/hyperinflation; I-bonds are a totally non-volatile hedge, with the U S Treasury setting the fixed rate and another bureau defining CPI-U.

I see merit in having an inflation hedge consisting of physical metal, a gold stock index fund, and I-Bonds. For someone living on a fixed income, such as a pension, it would be possible to compensate for inflation by systematically selling a regular portion, say 4% per year, of a well aged portfolio of I-Bonds and a gold index fund. Physical metal would be “last ditch”, probably not sold until a late-life dissipation exercise (such as buying a life annuity at age 70).