Savings accounts are paying a fraction of one percent, stocks have scared everyone half to death, and many reorganizations have bond holders’ debt being converted to equity. One safe alternative with a minimal downside and significant potential return.

Inflation

Inflation is the measurement of increase in the cost of living every year. Stated another way, it is the lessening of the dollar’s purchasing power over time.

Over many years, inflation averages about 2.5% per year, with large deviations from that mean. In English, that means that while the average is about 2.5%, some years, like now, inflation is virtually non-existent, and other years, like in the late 1970’s, it was over 13%. In years when inflation is high, the purchasing power of the dollar drops quickly. In years like present, the purchasing power of the dollar stays relatively constant.

At the average rate of inflation, the purchasing power of the dollar is cut in half about every twenty-five years.

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So much for the long term strategy of keeping your money in your mattress.

Monetary Policy

One of the mandates of the Federal Reserve Bank is to maintain price stability. That means it is expected to keep inflation under control. It does this by raising interest rates, slowing economic growth when the economy is growing quickly, and lowering interest rates when the economy slows, thereby increasing business borrowing and expansion. After having lowered interest rates to near zero, the Fed finds itself in the position where it must continue to stimulate a dangerously stagnant economy. Their strategy is to flood the economy with “stimulus money.”

This is money we don’t have. We are borrowing this money from ourselves, and have to pay it back – with interest. The Fed is, in effect, just “printing” this money.

What is the inflationary impact of such a strategy?

A Simple Example

We will create an economy consisting of five people with $5 each, or 20% each of the whole $25 economy.

One person buys goods worth $10 from another by using all his money and borrowing $5 from that other person. Now we have three people with $5, one person with $5 and a $5 loan, and one person $5 – that he owes to the lender.

If he pays his debt, the borrower will have no money. Ingeniously, he decides to print a brand new $5 bill and repay his debt with that newly printed money.

This economy now totals $30, of which each person with $5 has just under 17% (instead of the previous 20%), and the lender with just over 33% – instead of the 40% he would have owned if he’d been repaid with a dollar equal to the one he lent. Everyone’s money is now worth less in this new, larger economy.

As is true in this simple example, there is an inflationary impact in “printing money.”

Your Investments

The value of the stock and real estate market, both of which have performed well against inflation on a long term basis, has suffered badly in this economic downturn. Many investors have sought the protection of cash, or cash-equivalents like savings accounts, as a refuge for their wealth.

As we can see from the simple example provided, however, this is a flawed strategy. Over time, the value of this type of investment, net of inflation (and taxes), is negative, particularly in an environment of increased deficit spending. In short, it is guaranteed to lose money.

What, then, does a battle-worn investor do in this environment? What alternative exists for those who have found that they assumed more investment risk than they could tolerate with stocks and real estate?

Uncle Sam to the Rescue

He’s handed out money to the banking system that was on the verge of seizing up and bringing the entire economy to its knees. He’s handed out money to investment bankers and insurance executives that were doing things you may still not understand – but know it was bad, whatever it was. He’s handing out money to companies that make cars.

And he’s doing something for you, but you have to go get it yourself.

Tips

Treasury Inflation Protection bonds are investments that allow you to both

  • Lend money to your government until it pays back its national debt, and
  • Earn a guaranteed rate, at a stated percentage above inflation.

At worst, for the first time in history, a government will engage in huge deficit spending and NOT increase its rate of inflation. You will then earn a paltry sum over inflation and watch all your friends get rich in the stock market.

At best, inflation, currently at a historic low, will indeed rise, as will your earnings in excess of your loss in spending power. Your friends will secretly envy you, and you’ll be the hit of every cocktail party.

The reality is likely to be somewhere in the middle, but you will be lending to a borrower that is highly likely to repay you at a time when inflation is likely to rise.

Sound Good?

You know better than to put your money into anything without having investigated it thoroughly.

So far, you know it’s a loan to the US Treasury, which has, so far, had a perfect track record of paying back investors. Generally, Treasury investments are also free of State tax.

Now, go do your homework. No one investment is good for everyone.

Finished? Now, know that, even if you think this is a perfect investment for you, if you sell it before its maturity date, you can lose money. So choose a term that makes sense for your financial goal.