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Benchmarking Gold as an Inflation Hedge May 4, 2011

Posted by federalist in Finance.

I have long derided “gold bugs” and others who claim precious metals are the best hedge against inflation. Here’s another way to look at it: You can buy dollar inflation protection from the U.S. Treasury in the form of TIPS. By shorting a suitable index of treasury bonds you can virtually strip out the interest-rate exposure of the TIPS, producing an investment with a government-guaranteed real return.

Now ignore all my other arguments against buying precious metals as a hedge against inflation. Even assuming the gold bugs’ best case scenario — that gold retains its real value — you still have to pay storage and transaction fees on the metal, so an investment in gold has at least a slightly negative real rate of return.

Except for the last few months TIPS have sold with positive real rates of return. So any rational gold bug (I know, oxymoron) should prefer the TIPS real-return strategy to investing in precious metals when TIPS offer positive real returns.

Granted, there are two risks associated with using the TIPS real-return strategy:

  1. The inflation measure used to calculate TIPS values might differ significantly from what you value. E.g., TIPS price food, clothing, and shelter, but you want to preserve your ability to buy silver bullets and steam engines.
  2. The U.S. government could actually default on its debt.

I’ve admitted in the past I wouldn’t be surprised to see the Treasury inflate its way out of debt. But in the dire situation that the Treasury actually defaults on its debt I believe you’re mistaken if you think gold bars are going to be any comfort. At that point you’re going to want stockpiles of real real value.



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