Commodities as Inflation Protection

Abstract

Inflation degrades the function of the U.S. dollar as a storehouse of value. The goods and services which constitute the cost of living become more expensive in dollar terms. Commodities, and gold in particular, are often recommended to hedge that risk. Our work casts that popular advice into doubt, showing that inflation hedging with commodities is difficult, risky, and ultimately unreliable. Buy and hold strategies are impractical for many, and inflation hedging with commodities requires bold and successful management, together perhaps with good luck. Examining fifty-three years of spot prices for forty-five commodities and fourteen commodity aggregate indices, we find that owning certain things – specific commodities – rather than dollars would have been a better storehouse of value in the inflationary 1970s and in the brief period of high inflation from 1989-90. However, various commodities performed very differently in different periods, and some of the best in one period proved to be the worst in another. A basket of commodities to protect against inflation would be difficult to construct and in result. Furthermore, the precious metals, while often cited as inflation hedges, carry significant timing risks. Finally, a diversified basket of energy commodities has performed well under historical inflation, but carries its own risks.