Investing in Inflation Protection
Anand S. Iyer and Jennifer C. Bender/MSCIBarra/Nov 2010
The current tug of war between inflation and deflation has created considerable confusion for investors. Consequently, in this report we explore the characteristics of inflation-protected bonds [IPBs] to see if, and to what extent, these securities have contributed to portfolio diversification and provided investors with protection from inflation and deflation… We find that IPBs have exhibited some distinct differences from other asset classes during the past decade:
1) IPBs as an asset-class-level inflation hedge: We find that IPBs provided reasonable protection against inflation during this period…
2) IPBs in a deflation scenario: Nominal bonds had stronger protection (or put optionality) on deflation relative to IPBs during the last decade…
3) IPBs for portfolio diversification: The correlations of IPBs with other asset classes have been relatively low for equities, commodities, and real estate, and only slightly higher than correlations of nominal bonds with those assets.

Monetary Policy, Commodity Prices and Inflation: Empirical Evidence from the US
Florian Verheyen/University of Duisburg-Essen/Oct 2010
The past years were characterized by unprecedented rises in prices of commodities such as oil or wheat and inflation rates moved up above the mark of two percent per annum which is typically referred to as price stability. This led to a debate whether commodity prices indicate future CPI inflation and if they can be used as indicator variables for central banks. To answer this question, we have investigated what the connection between commodity prices and inflation is like in the US. After having looked at the economic theory which delivers reasons for and against a relationship between prices of both sorts of goods, we applied various econometric methods like Granger causality tests and SVAR models to answer this question. All these tools pointed to one conclusion. While there was a strong link between commodity prices and CPI inflation in the 1970s and the beginning of the 1980s, the relationship has weakened, respectively diminished over time. Today we are unable to detect a reaction of commodity prices to commodity price shocks. Thus, commodity prices might not serve as good indicator variables for monetary policy.
Are Commodities a Good Hedge Against Inflation? A Comparative Approach
Laura Spierdijk and Zaghum Umar/University of Groningen and Netspar/Nov 30, 2010
For long-term investors it is attractive to invest in assets that provide some protection against an increase in the general price level…Inflation hedging has become particularly relevant in the light of the subprime crisis of 2007, which resulted in the first major recession of the 21st century. To circumvent this financial catastrophe, unconventional tools such as quantitative easing and stimulus packages have been employed by regulators and policy makers. However, the efforts to overcome recession are likely to instigate inflation…
By analyzing the various commodities and sub-indices that are part of the S&P GSCI Total Return Index it turns out that non-precious metals provide the best inflation hedge. The similarities in the findings of the hedging measures can be explained from the fact that all but one measures boil down to an increasing function of the correlation between inflation rates and nominal asset returns.
The Debt-Inflation Cycle and the Global Financial Crisis
Peter J. Boettke and Christopher J. Coyne/George Mason University (via 21, 2010
…the debt-inflation theory of economic crises must be considered as a viable alternative to replace the debt-deflation theory of economic crises. Under the debt-deflation theory policymakers interpret every downturn in economic activity as a potential deflation, and therefore counteract it with easy monetary policy. When this happens market corrections will be cut short, and the previous boom is recreated through the manipulation of money and credit. Ludwig von Mises (1949) and F.A. Hayek (1979) were early expositors of an expectation based macroeconomics arguing that efforts to off-set economic downturns through monetary policy enter a dangerous game of expectations and anticipated inflation. As Hayek argued: ‘We now have a tiger by the tail: How long can this inflation continue? If the tiger (of inflation) is freed, he will eat us up; yet if he runs faster and faster while we desperately hold on, we are still finished!’ (1979, p. 110) It is this theory of the ‘crack-up boom’ (see Mises 1949, pp. 426-428 that very well may be what we have seen manifesting itself in reality with the onset of the Great Recession in 2008. If this is accurate then the policy steps taken to date have merely reinforced, rather than ameliorated, the problem as a market correction to previous malinvestments has been turned into a global crisis by the very steps taken to prevent the market correction from occurring.
Stock Returns and Inflation Risk: Implications for Portfolio Selection
Tomek Katzur/University of Groningen and Laura Spierdijk /University of Groningen and Netspar/Nov 30, 2010
This paper focuses on the exposure of common stocks to inflation risk and assesses the impact of this exposure on portfolio choice. We show that the relation between real stock returns and inflation rates, as well as the parameter uncertainty involved with this relation, has substantial influence on optimal asset allocations. During the 1985 – 2010 period, inflation risk induces a typical long-term investor to allocate up to 40 percentage points less of his wealth to stocks, as compared to a benchmark investor who believes that stocks are not exposed to inflation risk. The benchmark investor generally overstates expected stock returns and/or understates return volatility, resulting in too high stock allocations.
“Real‐Feel” Inflation: Quantitative Estimation of Inflation Perceptions
Michael Ashton/Enduring Investments LLC (via 27, 2010
The state of inflation expectations is generally supposed to influence actual inflation and
therefore policymaker actions to maintain price stability. However, the methods usually employed to evaluate inflation expectations are insufficient. Survey methods either record economists’ forecasts of official CPI, or consumers’ flailing attempts to calculate the weighted average price increase personally experienced in a consumption basket consisting of hundreds of items purchased at different intervals (and the latter survey results do not mesh with anecdotal evidence that most consumers believe the inflation they face is higher than the official CPI). In this paper, I propose functional forms for several adjustments that can be made to reconcile official price measurements with consumers’ perceptions.
These adjustments are corrections for cognitive biases related to loss aversion and mental accounting. I identify several other biases that may be candidates for research into additional adjustments…
In the case of inflation, although consumers are wrong about the actual pace of changes in prices, their perceptions matter. Their perceptions of inflation will affect their perceptions of real yields and, ergo, investment opportunities.20 Their perceptions may also feed more efficiently into price pressures via a cost‐push inflation mechanism. For example, workers who perceive a higher inflation rate may hold out for higher wage increases. If true, this will matter to policymakers.