How to Prepare for Inflation - TheStreet

Anyone inclined to look for silver linings can find one in the Labor Department’s latest inflation figures, which show that prices have gone up just 1.8% in the 12 months through the end of November.

That’s well below the long-term average of about 3%. And it helps take the sting out of low yields on bank savings, money markets and other fixed-income holdings. If you have a two-year certificate of deposit paying 1.374%, the average according to the survey, you’re losing a just a little to inflation while keeping your money safe and accessible.

But how should today’s low inflation rate influence a long-term investing and saving plan?

The financial markets expect inflation rates to stay low for years. That can be seen in the “breakeven rate” figured by subtracting yields on five-year Treasury notes from those on five-year Treasury Inflation-Protected Securities. The difference is about 1.6 percentage points, reflecting investors’ belief that inflation will average around 1.6% for the next five years. Investors expect inflation to average 2.25% over the next 10 years.

That, however, is no reason to let down your guard. Inflation is similar to investment returns, with the long-term average masking a lot of fluctuation. If you assume your investment return will average 7% a year, you should not go out and spend the excess if you earn 10% or 15% in a given year, since that excess gain is needed to offset the years your investments lose money.

In the same way, you have to keep preparing for significant levels of inflation even if the rate is low for the time being.

Also, the overall inflation rate is based on prices of thousands of goods and services that probably do not reflect your own spending. If you face college tuition or have a lot of out-of-pocket expenses for health care, your personal inflation rate may be a good deal higher than the average.

Even a minor increase in the long-term average can dramatically boost living costs in the decades to come. If inflation averages 3%, it will cost $1.80 in 20 years to buy what $1 buys today. (It’s $1.80 rather than $1.60 because inflation compounds just like interest earnings.) But if inflation averaged 4%, it will cost $2.19.

In preparing long-term plans, most financial experts assume inflation will average 3%, but it pays to build in a margin for safety. That’s one reason experts say even retirees should have sizable holdings in stocks, as stock returns tend to beat inflation by higher margins than bonds or cash.

Inflation and interest rates tend to move in tandem. That means low-inflation periods are generally bad times to lock money up in long-term fixed-income holdings with low yields. Today, the 10-year Treasury bond yields just 3.5%, meaning you would be losing ground if inflation were to rise above 3.5%. You’d kick yourself for tying money up at this rate if newer bonds paid 5% or 6%.

Short-term holdings, like one- and two-year CDs yielding 0.918% and 1.274%, respectively, aren’t as generous as 10-year bonds. But they will give you the opportunity to get at your money quickly to reinvest at higher yields if inflation and interest rates pick up.

Use the CD Ladder Calculator to find a good balance between yield and liquidity, and use the CD Shopping Tool to find CDs that are more generous than average. For example, ING Bank (Stock Quote: ING) has a 12-month CD paying 2%, more than double the national average, while Discover Bank (Stock Quote: DFS) has a 24-month CD paying 2.23%.

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