Inflation Hedges

The Federal Reserve recently announced a second wave of quantitative easing — promising to put $600 billion into the markets by buying up U.S. Treasuries. But instead of propping up the economy, the move really just opens the door to a wave of massive inflation.

It could get very ugly, so you need to understand exactly what’s about to happen and how to prepare for it.

Of course, as far as the Fed is concerned, inflation is firmly under control. After all, the core consumer price index — which excludes volatile things like food and energy costs — is very low. So low, in fact, that many investors believe we’re on the verge of a great deflation.

Trouble is, central bankers don’t seem to understand what inflation really is. Rising prices themselves aren’t inflation — they’re merely one of many potential outcomes of inflation.

True inflation is an increase in the supply of money in an economy. As Milton Friedman once said, “Inflation is always and everywhere a monetary phenomenon.”

So by that classical definition, the Fed injecting $600 billion into the economy fosters inflation. The message is, since we can’t grow our way out of this recession, the Fed will have to try to inflate our way out.

But don’t expect see its affect on prices for awhile. The Fed can control the amount of money in the system. But it can’t control what happens to that cash next.

That is, it can’t force banks to lend it out. It can’t force consumers or corporations to spend it. Without their cooperation, the velocity of money slows down to a crawl — and stagnant money has no effect on consumer prices.

But at some point, people realize their dollars are losing value, especially if there are rock-bottom interest rates. There will be a sudden urge to put their money into things with better yields… or to at least spend their dollars before they become worth even less.

The surge in spending increases money velocity — fast.  And just as quickly, prices increase. Forget the CPI jumping to 6%… it could easily go to 12%…or 25%…or 100%.

Then there are the people holding U.S. Treasuries to consider.

America is going to need to borrow an additional $1.6 trillion this year. And then keep borrowing $1 trillion-plus for years and years to come. There are no surpluses — ever again — in any plausible budget forecasts.

As you probably know, a good portion of that money will come from tax revenues. But the recent elections seek to lower those taxes. And if spending doesn’t follow suit, the government will need to rely even more on bondholders.

But what will the bondholders make of this? How long will they keep buying U.S. government debt before they worry about the government’s ability to pay it back? What if they see inflation increasing? (As inflation increases, their returns plummet because each dollar they receive is worth less.)

What if the Fed buying decreases bonds’ value? And what if the bondholders revolt — becoming the dreaded “bond vigilantes” — dumping their bonds and using the proceeds for other, more lucrative investments?

Exactly how it will play out is beyond the scope of the Daily Reckoning. Besides, we don’t know. But we do know what investments make the best inflation hedges.

Gold is at the top of the list. It’s what people always buy when they fear a crack-up in the monetary system. And that’s part of the reason the yellow metal is hitting historic highs.

Currently, you see ads for companies offering to buy your gold — in exchange for paper dollars. If people knew what was coming, they’d hold onto every piece of gold they own.

Another place to put your dollars while they still have value is Asia. The continent’s fast-growing economies promise strong returns as the America wanes.

Our favorite stock markets are China, India and Vietnam. And the preferred sectors are precious metals (of course), energy and industrials. Together these are likely to generate superior long-term returns.

Michael McLeod
for The Daily Reckoning

The Daily Reckoning