What Is an Inflation Hedge?
An inflation hedge is an investment that is considered to protect the decreased purchasing power of a currency that results from the loss of its value due to rising prices either macro-economically or due to inflation. It typically involves investing in an asset that is expected to maintain or increase its value over a specified period of time. Alternatively, the hedge could involve taking a higher position in assets, which may decrease in value less rapidly than the value of the currency.
- Inflation hedging can be used to offset the anticipated drop in a currency's price.
- Limiting downside risk is a major commonality between institutional investors and currency hedging is a common practice.
How Inflation Hedging Works
Inflation hedging can help protect the value of an investment. Certain investments might seem to provide a decent return, but when inflation is factored in, they can be sold at a loss. For example, if you invest in a stock that gives a 5% return, but inflation is 6%, you are losing that 1%. Assets that are considered an inflation hedge could be self-fulfilling; investors flock to them, which keeps their values high even though the intrinsic value may be much lower.
Gold is widely considered an inflationary hedge because its price in U.S. dollars is variable.
For example, if the dollar loses value from the effects of inflation, gold tends to become more expensive. So an owner of gold is protected (or hedged) against a falling dollar because, as inflation rises and erodes the value of the dollar, the cost of every ounce of gold in dollars will rise as a result. So the investor is compensated for this inflation with more dollars for each ounce of gold.
A Real World Example of Inflation Hedging
Companies sometimes engage in inflation hedging to keep their operating costs low. One of the most famous examples is Delta Air Lines purchasing an oil refinery from ConocoPhillips in 2012 to offset the risk of higher jet fuel prices.
To the extent that airlines try to hedge their fuel costs, they typically do so in the crude oil market. Delta felt they could produce jet fuel themselves at a lower cost than buying it on the market and in this way directly hedged against jet fuel price inflation. At the time, Delta estimated that it would reduce its annual fuel expense by $300 million.
Limitations of Inflation Hedging
Inflation hedging has its limits and at times can be volatile. For example, Delta has not consistently made money from its refinery in the years since it was purchased, limiting the effectiveness of its inflation hedge.
The arguments for and against investing in commodities as an inflation hedge are usually centered around variables such as global population growth, technological innovation, production spikes and outages, emerging market political turmoil, Chinese economic growth, and global infrastructure spending. These continually changing factors play a role in the effectiveness of inflation hedging.