Inflation Tracking Portfolios
We propose a new approach to constructing inflation tracking portfolios. The key to this approach is the insight that asset returns track expected inflation far better than they track current realized inflation. Thus, we can construct portfolios that track next month's inflation much more closely than they track this month's inflation. We show this staggered hedging approach can eliminate nearly 90 percent of the tracking error of more conventional inflation hedging strategies. We also find that long-short positions in equities play a dominant role in the effective hedging of inflation risk over extended horizons. These results suggest that the goal of protecting portfolios against inflation may be more feasible that is commonly believed.
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