Obama and inflation: Will Bernanke weaken the dollar?

(MoneyWatch) The election is over and two top dogs will keep their jobs. With the reelection of President Obama, Ben Bernanke's job as Chairman of the Federal Reserve Board is safe until the end of his second term (Jan. 31, 2014). BB's job was at risk if the election went the other way, because Mitt Romney had said that he "would like to select ... a new person to that chairman position, someone who shared my economic views" and he doubted the efficacy of recent monetary policies.

The status quo means that the Federal Reserve will continue its third round of "Quantitative Easing," which amounts to the purchase of $40 billion per month of mortgage-backed securities. The intended goal of QE3 is to spur economic growth and help reduce unemployment. Whether or not the plan will work is subject to debate. What is not debatable is that the Fed's actions caused candidate Romney -- and other Fed critics -- to predict that it would "seed the kind of potential for inflation down the road that would be harmful to the value of the dollar and harmful to the stability of our nation's needs."

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Inflation occurs when the prices of goods and services rise and as a result, the purchasing power of your dollars falls. The annual rate of inflation over the past 60 years or so has averaged about 3.8 percent annually. That might not sound like much, but consider this: today you need $8,693.55 in cash to buy what $1,000 could buy in 1952.

Inflation is currently running well below the long-term average. As of September, the government's measure of inflation, the Consumer Price Index (CPI), has increased only 2 percent over the last 12 months.

However, the Fed's strategy to flood the economy with money could eventually unleash inflation, and you should  guard your savings against that possibility. The key is to grow your portfolio at a quicker pace than the rate of inflation, while keeping focused on the total risk level you are willing to assume. Not an easy puzzle to solve. And here's one more sobering thought: There is no single asset that has acted as a perfect inflation hedge.

The following are the investments most frequently used to protect portfolios against inflation:

Commodities: When inflation rises, the price of commodities such as gold, energy, food and raw materials also increases. Many investors therefore turn to investments in these assets for protection, but as a former commodities trader, I must warn that this is a volatile asset class that can also stagnate or worse, lose money, over long stretches of time. Therefore, investors would be wise to limit commodity exposure to 3 - 6 percent of the total portfolio value.

Real estate investment trusts (REITs): Real estate is the ultimate "real asset," so REITs tend to perform well during inflationary periods, due to rising property values and rents. But the nation's housing bubble has cured most of us of the notion that you "can't lose with real estate." Real estate prices could stay depressed for a long period of time.

Stocks: Many investors don't think about stocks as an asset class to combat inflation, but the long-term data show that stocks, especially dividend-producing stocks, tend to perform well in inflationary periods. That said, during short-term inflationary spikes, stocks can plunge quickly before reverting to the longer-term trend.

Treasury Inflation Protected Securities (TIPS): Bonds are susceptible to inflation, because rising prices diminish the value of a bond's fixed-income return. But the U.S. government directly offers investors inflation-indexed bonds, or TIPS, which provide a fixed interest rate above the rate of inflation, as measured by the CPI. Sounds great, right? Unfortunately, because the expectation of future inflation is currently running high, investors are paying up for TIPS, which has driven the interest rate on these bonds below zero. (On Aug 23, the U.S. sold $14 billion of five-year TIPS at a record low auction yield of negative 1.286 percent.) That's not a typo: investors are so worried about inflation they are willing to pay the government now to protect them later. The current pricing of TIPS makes them hard to recommend, even as an insurance policy vs. inflation.

International Bonds: One of the dangers of inflation is that it destroys the value of the U.S. dollar. As a result, there is an argument to allocate a small portion of a bond portfolio to international bonds, which are denominated in a foreign currency. This is another one of those asset classes that tends to be volatile.

While inflation may be looming, it's important to underscore that a diversified portfolio, which takes into account your time horizon and risk tolerance, will go a long way toward providing protection. If you are worried about inflation, these other asset classes should be used sparingly to round out your overall allocation.