Who Needs Inflation Hedging?

Using formal intertemporal spanning tests, we find that interest rate risk dominates inflation risk so dramatically within instantaneous liability risk that introducing or removing inflation-linked bonds, or real estate and commodities, from their liability-hedging portfolio has relatively little impact on investors’ welfare from a shortterm perspective. This holds true in spite of the attractive (in the case of real assets) and even perfect (in the case of inflation-linked bonds) inflation-hedging benefits of some of these asset classes. More substantial welfare gains/losses, comparable to the costs of ignoring equity return predictability, are obtained as the time-horizon converges towards the liability maturity date and as the relative importance of inflation risk within liability risk  increases. Even more substantial utility gains are obtained if these asset classes are also used in the performance-seeking portfolio, where they provide diversification benefits with respect to equity returns.