I’ve been reading a couple of different things lately that suggest the U.S. is headed for a period of higher inflation. I can think of a few items that are clearly heading that way like health care, education, and gas. It got me wondering what the best action to take is if you expect a rise in inflation.

I know the most common inflation hedge is gold. The problem with that as I see it is gold has had an enormous run-up lately. It’s gone from around $300 per ounce five years ago to pushing $700 today. That looks like buying at the top to me. Besides, I’m not entirely sure of the mechanism involved.

TIPS (Treasury Inflation-Protected Securities)

Inflation-protected Treasury securities is another option.  You can’t put a large portion of your portfolio in TIPS, though. The yield is too low for most situations.

I wanted to write a bit more about TIPS (Treasury Inflation-Protected Securities) and a peculiar tax treatment quirk they have. As you recall, TIPS have an underlying rate and an inflation-adjusted rate added on top. Because they’re inflation-adjusted though, if you don’t hold them in tax-deferred accounts, you could be hit with a rather insidious tax issue.

You’re taxed on the income from your bond. If inflation is low, your apparent income, and thus taxes, are low. However, if inflation is higher, you will have an apparently larger income from the bond even though your real (after-inflation) rate of return is the same as before. For example, say you have a TIPS with a nominal rate of 4% and inflation is running 4%. You’re getting paid 8%. Say you’re taxed on that in the 25% bracket. You’re really getting 6% after taxes and your real return is 2% after inflation. Now let’s say inflation rockets to 12%. Now you’re getting paid 16% nominally (but still 4% real). Now you’re only getting 12% after taxes (75% of 16%). After inflation, you’re not making a dime. Nice, huh?

This is sometimes known as the ‘tax on the inflation tax.’ And it’s another reason why you should keep TIPS in tax-deferred accounts.

A third possibility is ‘hard’ assets like REITs or natural resources. For REITs, it’s the same fundamental problem as gold. The price of real estate has run up recently. I think there’s not much gas left in REITs. As for natural resources, I don’t know anything about timber, oil, or natural gas. That’s out.