How to Beat Inflation

Alan Greenspan, the former chairman of the federal reserve, in his new book and in the excerpt printed in newsweek, writes that he believes America is on the verge of a gradual rise in inflation to a trend-line rate of 4 to 5 percent or higher. This forecast has received virtually no atten tion in the media barrage that has been focused on "The Maestro," but if he is right, it has immense implications for everyone with some wealth and retirement funds.

Greenspan writes that the long period of disinflation that began in the mid-1980s and that generated prosperity and a bull market in stocks and bonds is over. "To day's relative fiscal quiescence masks a pending tsunami. It will hit as a significant proportion of the nation's highly produc tive population retires to become recipients of our federal pay-as-you-go health and re tirement system, rather than contributors to it." Benefit funding for boomers is inade quate, and Greenspan is clearly not opti mistic that a dysfunctional, populist politi cal system will address this issue.

The easy way for politicians to post pone dealing with really hard problems is to run deficits and print money. Greenspan worries that the Federal Reserve will not have the independence to curb the result ing inflation. As he points out, "An infla tion rate of 4 to 5 percent is not to be taken lightly—no one will be happy to see his or her saved dollars lose half their purchasing power in fifteen years or so." Reading be tween the lines, I suspect he thinks infla tion could go considerably higher before "policy sanity" is restored.

Higher and rising inflation is categori cally bad. The remarkable prosperity the U.S. economy and the world have enjoyed for more than a decade has been a conse quence of low, stable inflation. Higher in flation creates uncertainty and distortions, saps the underlying strength of the econo my and causes steeper and more volatile business cycles. There is always the possi bility of the economy's slipping into bouts of stagflation.

Greenspan is a very smart and, even bet ter, a very wise man. However, with great respect, I am not sure he is right. The booming developing economies now ac count for 30 percent of global GDP and have 85 percent of the world's work force laboring at less than $5 a day. They are go ing through both the industrial and techno logical revolutions at the same time. These countries export low-cost goods and have massive excess labor, so they depress wages and prices everywhere. They are accumu lating huge sums of money that they rein vest in new capacity to produce things that run the gamut from iron ore to TVs and dress shirts. They are a very powerful force for disinflation, just as populist govern ments are powerful forces for inflation.

However, let's assume Greenspan is right. What will be the effects of higher in flation, and what should an investor do about it? Above all, an investor has to look through the money illusion and focus on preserving and enhancing the all-important purchasing power of his money. Fifteen years from now, $500,000 will not be the same and will not buy the same lifestyle as $500,000 today if inflation averages 5 per cent. With people retiring earlier and living longer, a 15-year timeline may be too short. Maybe it should be 30 years. At the end of 15 years of 5 percent inflation, you will have lost 52 percent of the purchasing pow er of your capital. In other words, fixed-in come investments that you bought so you could live on your income don't work.

However, there are ways to combat the effects of inflation. First, don't own bonds. As interest rates rise, their price will fall. Instead, TIPS (Treasury Inflation-Protect ed Securities) are an inflation-proof way to maintain the purchasing power of your money. Without going into a complicated explanation, TIPS are Treasury bonds whose interest payment consists of a real yield of about 2.3 percent currently on the 30-year TIPS, plus an automatic adjust ment for the inflation rate. In other words, the purchasing power of your annual in come from your bonds is going to grow at the rate of 2.3 percent a year for the next 30 years. The real yield on TIPS does change, but within a relatively narrow band. Not thrilling, but nice and safe.

It's also important to remember that if inflation is high and rising, you want to be a debtor or an owner of assets, not a credi tor. If you borrow money, you are paying back your loan with depreciated dollars. Theoretically, an apartment house bought with borrowed money, in which rents are rising faster than inflation, could be an ide al investment. Farmland, timberland or any asset class that generates rising income would also be a good inflation hedge. Tra ditionally, gold has been a fine inflation hedge, as are art and jewelry.

As long as the inflation rate doesn't get too high and too volatile, stocks should work. Again, you are an owner of a business with real assets and presum ably with rising earning power and divi dends. Of course, selection depends on val uations and specifics, but theoretically you'd want to buy into companies that are inflation beneficiaries—chemicals, energy, forest products, steel, aluminum and own ers of great franchises. Because technology ameliorates the inflation problem, it be comes more valuable. But above all, avoid bondlike equities.