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Between fears of a new oil shock and the Fed's money-printing, it's only natural for investors to be concerned about the risk of inflation. If you want to manage that risk intelligently, make sure the following four myths don't trip you up.
Myth No. 1: Rising oil prices will necessarily cause inflation
It was no coincidence that two oil shocks marred the 1970s, the last period of significant U.S. inflation. However, the link between oil price increases and inflation appears to have weakened since 1980. There's a huge wild card, though: the Fed. In trying to explain why higher oil prices have had less of an effect on inflation over the past 30 years, economists -- including Ben Bernanke -- have seized on increasingly aggressive Fed policy as an explanation. The Fed has shown itself more willing to try to counteract the effects of oil price increases (among other things it's been more willing to get involved in).
Sure enough, last Friday, Fed Vice Chairman Janet Yellen declared that the Fed "couldn't sit by" if higher oil prices started feeding through to inflation. But however much she talks the talk, raising interest rates will be a lot trickier while the economic recovery remains fragile.
Myth No. 2: Inflation is underreported by the government
This is a widespread myth supported by an entire arsenal of false arguments. I think this myth is so persistent because people don't find that the government's consumer price index reflects their experience of inflation. But there are multiple explanations for this that don't require a government conspiracy to underreport inflation.
First, the CPI is an average calculated over an extremely broad basket of goods and services; different people consume different subsets of that basket, so it's quite natural that some people will experience higher-than-average inflation. Second, people may overestimate inflation due to "loss aversion": They feel the loss of purchasing power associated with rising prices more acutely than increases in buying power that result from falling prices.
And falling prices do occur: Last year, for example, Wal-Mart Stores (NYSE: WMT ) reduced prices on more than 10,000 items, including a 22% price cut on Procter & Gamble's (NYSE: PG ) Tide laundry detergent, for example. In fact, on exiting the recession, Procter & Gamble proactively waged an aggressive price war against rivals Colgate-Palmolive (NYSE: CL ) and Unilever (NYSE: UN ) , as well as private label brands. (This year, however, Procter will be raising prices, and I expect its rivals to follow suit.)
Myth No. 3: Gold is an effective inflation hedge
This is a half-myth: As I showed here, gold has preserved purchasing power, but it has only done so reliably over the very, very long term. Over practical holding periods, however, gold doesn't appear to be an effective inflation hedge. Owners of gold-backed products, including the SPDR Gold Shares (NYSE: GLD ) or the Sprott Physical Gold Trust ETV (NYSE: PHYS ) , are forewarned. There may be good reasons to own gold during certain periods -- the yellow metal offers some diversification with regard to stocks, for example -- but fear of inflation isn't one of them.
Myth No. 4: Stocks are an effective inflation hedge
All right, this last one is no myth. When investors purchase stocks at reasonable prices, they can expect to earn a positive inflation-adjusted return (over an adequate holding period). But it's important to understand one caveat: Stocks don't automatically protect investors during any specific period in which inflation is flaring up.
In the two-year period from 1973 through 1974, the CPI rose 22%; the S&P 500 only added insult to injury, losing 42% of its value. Stocks are a claim on companies' earnings, and, sure enough, S&P 500 earnings grew faster than inflation over that period. "So what went wrong?" you ask. The trouble was that investors didn't want to own stocks and had sold them down to cut-rate valuations, overwhelming the positive effect from earnings growth. The same phenomenon occurred during the inflation spike of 1946-1947.
It's also worth pointing out that not all stocks are created equal in terms of inflation protection. Which companies are best able to pass on rising costs (and more!) to their customers through price increases? Pricing power is the privilege of businesses that are able to differentiate themselves from their competitors or that produce goods or services people must have. The consumer stocks I mentioned earlier fall into that category. If you're concerned about inflation, take comfort in the fact some of the great franchises in American business are available at reasonable prices right now.
If you want specific ideas of inflation-beating stocks, the Motley Fool's top analysts have identified 13 High-Yielding Stocks to Buy Today.
Wal-Mart Stores is a Motley Fool Inside Value recommendation. Wal-Mart Stores is a Motley Fool Global Gains pick. Procter & Gamble is a Motley Fool Income Investor recommendation. Motley Fool Options has recommended a diagonal call position on Wal-Mart Stores. The Fool owns shares of Sprott Physical Gold Trust ETV and Wal-Mart Stores. Try any of our Foolish newsletter services free for 30 days.
Fool contributor Alex Dumortier, CFA has no beneficial interest in any of the stocks mentioned in this article. You can follow him on Twitter. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.