What is an Inflation Hedge?
An inflation hedge is an investment to protect against the loss of buying power from a currency’s value going down because of inflation or prices going up in the economy. It usually means putting money into something that you think will keep or gain value over a certain amount of time. Alternatively, the hedge could buy more assets that may lose value more slowly than the currency.
How Hedging Against Inflation Works
A hedge against inflation can help keep an investment’s value safe. When inflation is considered, some purchases may look like they’ll give a good return. However, they can be sold at a loss. For instance, if you buy a stock with a 5% return but inflation is 6%, you lose that 1%. If you think of an asset as a hedge against inflation, it may be self-fulfilling: investors rush to buy it, which keeps its value high even if it has a much lower real value.
Many people think gold is an excellent way to protect against inflation because its value in U.S. dollars constantly changes.
For example, gold tends to cost more when the dollar’s worth drops because of inflation. Since inflation makes the dollar worth less, people who own gold are protected against the dollar dropping. This is because as inflation rises, the price of every ounce of gold in dollars will go up. This means investors are getting more money for each ounce of gold because of inflation.
An example of hedging against inflation from real-life
Hedging against inflation is sometimes done by businesses to keep their running costs low. In 2012, Delta Air Lines bought an oil refinery from ConocoPhillips to protect itself against higher jet fuel prices.
When planes try to keep their fuel costs down, they usually do so in the crude oil market. Delta thought they could make their jet fuel for less money than buying it on the market. This was seen as a straightforward way to protect themselves against rising prices for jet fuel. At the time, Delta thought it would save $300 million a year on fuel costs.
Problems with Hedging Against Inflation
Hedge funds dealing with inflation have boundaries and can sometimes be unstable. Delta hasn’t always made money from its plant since it was bought, for example, making its inflation hedge less effective.
Usually, the pros and cons of investing in commodities to protect against inflation are based on population growth, new technologies, production spikes and outages, political unrest in emerging markets, Chinese economic growth, and infrastructure spending around the world. These things that are constantly changing affect how well inflation protection works.
Conclusion
You can use inflation trading to protect yourself from the expected drop in the value of a currency.
Limiting downside risk is something that all institutional investors do, and hedging currencies is a popular way to do this.
