So what’s the best way to hedge against inflation?

So what’s the best way to hedge against inflation? It’s not some exotic derivative or shiny metal that has been used for thousands of years as money and has who knows how many other nice stories to go along with it. It won’t earn your broker any commissions or fees, and it won’t cost you anything to store, but it will tirelessly maintain the value of your money as inflation continues its never ending assault. And the magical investment is… the humble bank account of course! Interest rates are inherently linked to expected inflation and consistently fluctuate with it over time. In fact, if you had locked your money in for one year in a term deposit (I used the average of the term deposits at the five largest banks, available on the RBA website) each year, over fifty percent of your return would be explained by the ebb and flow of inflation. The correlations for more liquid savings accounts are even higher (I chose not to use online savings accounts even though they would have suited the study better because there was only data going back six years).

Now THIS is what a plot of two positively related variables should look like! You can clearly see that as the inflation rate in a year (on the horizontal axis) gets higher, the average one year term deposit rate at the beginning of the year (vertical axis) gets higher too. To heck the numbers out see Comparing inflation to term deposits.

This is partly due to the RBA’s countercyclical manipulation of the interest rate to slow the economy. When inflation is too high the RBA will raise the interest rate to slow lending, which will automatically increase the return you get on your savings. However the mechanism which ensures that your return’s increase when inflation increases are somewhat subtler and more beautiful than this. At the beginning of the twentieth century Irving fisher said that interest rates provided people who saved with a “real” return or reward for forgoing their spending until a later date (because as intrinsically greedy human beings we would generally rather spend our money on a new toy now rather than wait) plus a little bit more to compensate people for the fact that everything was going to be a little bit more expensive by the time they got their money (inflation). And since then not much else has been said. But people need to be compensated for these two things to be induced to save instead of enjoying their money now. If savers (in particular large businesses) feel that the interest rates are not sufficiently compensating them for the increases in prices over the coming year (the "expected" inflation) they will take their money out of banks and spend it now, before the price rises. This leaves banks with less money than they require, so they put up their interest rates to coax money back in. A savvy investor like yourself has just hedged your return against inflation without doing anything, and more importantly with paying anything.

Many famous investors, most notably Warren Buffett, have commented on the fact that gold is a boring, inert metal with little industrial use, and which pays no dividends or interest (I now add myself to this illustrious list ;-). A bank account is easy and free to invest in, require no analysis to identify suitable entry points, and it pays you, like any good investment should.

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