An Easy Inflation Hedge

The best way to hedge against inflation is to buy “stuff”.  You wouldn’t want to buy bonds or an annuity, as you will get paid back in depreciated dollars.  When you buy stock, you are buying a very small piece of ownership in a company.  Some of this represents buildings and other equipment that the company may own.  But buying stocks is certainly not a very good way to hedge against inflation.  In an inflationary environment, the economy may be in very poor condition and, hence, company profits also do poor.

Gold is still one of the best hedges against inflation.  In a mild inflationary environment, gold may not do all that great.  But if price inflation starts going at 10% per year or higher, gold will likely do well.  Not only will it keep up with the price increases, it will probably go up much higher in real terms.  If prices start going up at a 20% annual rate, you could easily see gold going up at 50% or 100% per year.  That is what makes it a great hedge.  You can have just 25% of your portfolio in gold and it will protect your entire portfolio from inflation as demonstrated in the above example.

There is also another way to hedge against inflation, and you may already do this a little bit.  It is not nearly as good as buying gold and it should not replace buying gold, but it is easy.  If you have some extra space where you live, you can buy things that you know you will use in the future.  Perhaps you are going to need a new appliance of some sort.  Maybe it is better to get it now before prices go up.

There are many bad things that Federal Reserve inflation causes.  It allows for big government politicians to spend more.  It causes boom and bust cycles.  The obvious bad thing is that it causes prices to rise.  You can buy things now instead of later when the price goes up.  This goes even for small things.

You obviously can’t buy milk right now that you are going to use next year, but there are a lot of things that don’t have near-term expiration dates.  You can buy toilet paper, razor blades, canned soup, soda, paper towels, soap, laundry detergent, etc.  All you need is a little extra space to store it.  If you see a good sale at the store, why not buy a few extra things if you have a little extra cash laying around?  Just make sure you use the FIFO method of accounting (first in, first out).  In other words, use the older stuff first.

Again, this isn’t to replace gold or anything else as an investment hedge.  But it could save you a few depreciated dollars in the future.  If you knew that dishwashing soap would cost 8 dollars next year and you can buy it for 3 dollars this year, why wouldn’t you buy a few extra now, especially if you have the money to buy now?

Inflation and Prices

One topic that libertarians/Austrian economists discuss is the definition of inflation. Inflation is generally defined by Austrians as an increase in the money supply. This was the original definition of inflation. Now, when people use the term inflation, they are usually referring to a general rise in prices of goods and services. The statists have changed the definition over time to suit their agenda.

When inflation is defined as a rise in prices, then it is easier to blame big business, speculators, greed, etc., rather than blaming the actual culprit, the Federal Reserve. When inflation is defined as an increase in the money supply, then it is obvious that the Fed is to blame, since the Fed is solely responsible for creating money out of thin air.

It is important to differentiate between monetary inflation and price inflation when necessary. With that said, monetary inflation will usually lead to price inflation. The only thing that can offset an increase in the money supply is having the banks increase reserves (which is happening now) or to have an increase in the demand for money (which is also happening now). If people decide not to spend as much money, then prices could still go down or remain the same, despite an increase in the money supply. People might do this because they are fearful of the future or perhaps they expect the money supply to tighten up in the future.

It is also important to note that when there is price inflation, it is not necessarily uniform. From the late 1990’s to about 2006, prices were going up, but housing prices were going up much more. After that, housing prices went down (when the bubble burst) even though most other prices were not going down (think food).

If you are ever talking about inflation, make sure to differentiate between monetary inflation and price inflation if it is relevant to your discussion. Although they are often related, they are not the same thing.


It is always dangerous to make predictions. All we can really do is take our best guess based on the facts that we have. It really is amazing how many people make crazy predictions though and they are things that are completely beyond our control. It even happens with libertarians.

If you have a basic understanding of Austrian economics, then you should understand that economics is really a study of human action. Human Action is the name of Mises’ biggest and most famous book. You should understand that economic activity is made up of the decisions of millions of different people acting in their own way.

If we are going to make predictions, they should be reasonable. For example, if the money supply goes way up (and the money doesn’t sit as excess reserves at banks), then it is reasonable to predict there will be price inflation. But we should realize that this isn’t even a guarantee. It is likely, but not a guarantee. The money supply could double, but it is technically possible for the demand for cash to increase dramatically and for prices not to go up.

It is also reasonable to predict that politicians will continue to try to spend more and more money and make government bigger and bigger. It is generally a safe bet. But again, you are predicting the behavior of individuals. It is possible that a bunch of politicians will see the light and become honest and make government smaller. It is highly unlikely, but not necessarily impossible.

But then you get completely ridiculous predictions. There are predictions that we will have hyperinflation, or war with Iran, or a new world order, or a new currency in the next year. There wouldn’t be anything wrong with these predictions if the people making the predictions admitted that it is only their best guess based on the circumstances. But for some people to make it sound like it is an inevitability is crazy. If it were Ben Bernanke predicting hyperinflation, we might want to listen because he might be able to make it happen. But everyone else is predicting human behavior and they shouldn’t be so certain about their predictions.

If someone makes a prediction and says it like they are guaranteeing the outcome, you should think twice about listening to what they are saying. You can take a guess at human behavior, but you can never be certain.

Gold Price and Interest Rates

This has been discussed here before, but it is an important point to mention again. The price of gold (compared to the U.S. dollar) has done well in the last few years and especially well in the last 10 years. There is a lot of uncertainty in this world and the rise in price is certainly justified.

Although some people are fearful of inflation down the road (and probably rightly so), it is not a huge factor right now in the price of gold. The reason for this is interest rates. If massive inflation were an imminent threat, interest rates would not be so low right now. Investors in bonds would demand a higher rate to compensate for the threat of inflation (being paid back in depreciated dollars).

While the gold price can still go higher, barring some catastrophe, the price is not likely to explode until we see interest rates go way up. Higher interest rates will signal the threat of high inflation as bond investors demand higher rates.

With all of that said, don’t try to time things too much. If you don’t own gold, get some. If the price drops, get some more.

Can the Fed Successfully Exit?

That is the title of an important article posted on the Mises Institute’s site today. It explains a couple of important points that have been made on this blog.

First, the reason we have not seen high price inflation is because most of the new money created by the Fed in the last couple of years has gone to the banks. The banks have kept this money as excess reserves and have been unwilling or unable to lend it out.

Second, the Fed will have trouble exiting its “quantitative easing” (creating money out of thin air) from the past. When the Fed created this new money, much of what it bought were bad assets. For instance, it bought mortgage backed securities that are considered subprime. The bottom line is that these assets are not worth near as much as what the Fed paid for them.

If the Fed paid $1 trillion dollars for some bad assets that are really only worth $600 billion, then the Fed could only sell back these assets on the open market for $600 billion. What happened to the other $400 billion? It is new money in the system. If it sits on reserve with the Fed, this helps keep a lid on price inflation. If it finds its way out of the banks, it will eventually cause price inflation.

The Fed is in a tough place. It will not be as easy as they say to “exit”. Watch the adjusted monetary base and watch the excess reserves held by banks. This will be your guide in preparing for high price inflation.

Harry Browne

Sometimes there will be certain themes repeated on this blog. It is only to serve as a reminder (probably because the issue is important) and also for the benefit of new readers.

Harry Browne, best known as the presidential candidate on the Libertarian Party ticket in 1996 and 2000, was also an investment advisor. He became somewhat famous by predicting the devaluation of the dollar and also the surge in gold in the 1970’s. Later in his career, he wrote a book called “Fail Safe Investing”. This book is highly recommended if you can get a copy. There are a lot of simple but important tips in it.

The best part about the book is his explanation of his permanent portfolio. Basically, he suggests dividing up your investments into 4 parts: cash, long-term U.S. bonds, stocks, and gold. It is explained in more detail in his book. If you have trouble sleeping at night because of your investments, this is highly recommended. It will do good in most times and for the short periods where it has lost money, it hasn’t been much. For instance, in the fall of 2008, the portfolio would have gone down, but a lot less than someone with all of their money in stocks. In addition, it made a nice comeback and would be higher today (also unlike stocks).

In Harry’s book, he recommends this permanent portfolio but says that there is nothing wrong with speculating with other money you have, as long as it is money that you can afford to lose.

A good plan of action: take 75% of your money (more if you are conservative, less if you are a gambler) and put it in the investments suggested for the permanent portfolio. There is also a mutual fund (symbol: PRPFX) that invests similarly to the permanent portfolio. Then you can speculate with the other 25% or whatever you decide. For instance, you could leave it in cash waiting for an opportunity or you could buy gold options or you could split it up into your favorite gold and oil stocks. But again, this is money that is somewhat of a gamble. It is money that you should be able to afford to lose. If you can’t afford to lose it, then put all of your money into the permanent portfolio. You will sleep better at night.

The Monetary Base and Excess Reserves

Take a look at these two charts:

Adjusted Monetary Base

Excess Reserves

If you look at them together with the same time period (1 year, 5 years, etc.), they look very similar. This is no coincidence. In the fall of 2008, the Fed began creating money at an unprecedented rate. It eventually more than doubled the monetary base, which is really the monetary chart that the Fed most controls.

When the Fed created all of this new money, it went to the banks. The banks were, and still are, scared to lend. They are afraid of future defaults (and probably rightly so). They would rather keep their excess reserves sitting at the Fed earning less than .25% interest instead of lending out this money. The banks could loan out this money as they are only required by law to keep about 10% on reserve.

The fact that the banks have kept these excess reserves with the Fed instead of loaning out the money is what has kept price inflation from skyrocketing. If the banks start to lend and the Fed doesn’t reign in this new money, then we will see prices jump substantially. Keep an eye on these two charts. If the monetary base goes up without excess reserves going up, or if the monetary base stays about the same with excess reserves going down, then you should be prepared for massive price inflation and should prepare your investments accordingly.


Yesterday, I wrote on the low mortgage rates. There is a strong benefit to buying a house right now. Prices are low compared to what they were a few years ago and rates are low. If you aren’t buying a house for investment purposes (to rent, fix up and sell, etc.), then buying a house is buying a consumable good. Spending more on a house is not necessarily a good financial move. But taking a vacation to the Alps is not necessarily a good financial move either. There is nothing wrong with buying your dream house or just a house with a little more than needed, but you should be able to afford it and you should not consider it an investment.

While there is a good argument to buying a house right now with a fixed rate mortgage, it does not mean that goes for everything else. You need to live in a house (or some kind of shelter) and although it should depreciate over time, in most cases they appreciate because of the land and because of inflation. There is also a good argument that with a fixed rate mortgage, you will be paying back the loan in depreciated dollars.

Although inflation benefits borrowers, it doesn’t mean that you should collect debt. If you need a car right now, then of course you need to buy one for transportation. But cars depreciate, so it is the opposite of an investment. The investment is the transportation part of it (getting to your job, to the store, etc.). Anything beyond the transportation part is really a luxury. It is not to say that you shouldn’t get certain features that you may want, but it is to say that you are making a bad financial decision if you buy a $30,000 car while your net worth is not even that much.

Debt is a bad thing, generally speaking. You are wasting money on things that you don’t need. You should only go into debt for something like a house or an inexpensive car that you need for transportation. You should never go into credit card debt unless you need to in order to put food on the table.

Stay away from the bad debt.

Mortgage Rates

Mortgage rates continue to be at or near all-time lows. You can get a 30 year fixed rate mortgage for just over 4.5% if your credit is decent. If you own a home and plan to stay there and your rate is above 5.5%, refinance it if you can. If you are buying a home, get the fixed rate mortgage for 30 years.

Under normal conditions, I am an advocate of paying off your mortgage if the rest of your financial situation is in order. If you have a 6% rate, you can pay down your mortgage and get the equivalent of a 6% rate of return on your investment.

With rates as low as they are now and with potentially high inflation in the future, you probably can’t go wrong with a 30 year fixed rate for under 5%. You should obviously have payments that you can afford. If you get a fixed payment of say $1,000 a month, when you make that last payment in 30 years (assuming you keep the house for that long), that payment might be the equivalent of a nice dinner out.

Can We Stop Deflation?

A week or so ago, I heard a commentator on CNBC say that we should be worried about deflation because inflation can be stopped at any time, but that you can’t stop deflation. I have been hearing this theme surprisingly often lately. If you hear anybody say this, don’t ever take advice from them on anything dealing with economics because they have no idea what they are talking about.

If anything, inflation is the thing that could possibly not be stopped. The Fed bought up a bunch of near worthless assets back in 2008 and they will only be able to sell them back at a fraction of the price for what they paid. One option for fighting inflation down the road would be to increase the reserve requirements for banks, but even this is not a sure thing and beside the fact that it would not be supported by the banks (which work hand-in-hand with the Fed).

As far as price inflation goes though, if the public realized one day that the deficits are too high and our fiat currency is not backed by anything (like gold) and that the Fed will create mass quantities of new money, then a rush to the exits could mean the end of the dollar. If the demand for money goes down enough (high velocity), then it may not even matter how much money the Fed is creating. If enough people reject the currency, this in itself could sink it.

But let’s move on to the deflation issue. This guy (and there are many more like him) think that the Fed can’t stop deflation. Seriously, does this guy know anything about what the Fed does? The Federal Reserve can buy any asset that it wants with newly created money. The Fed could start buying stocks, old furniture, baseball cards, or farmland. Or it could keep buying U.S. treasuries. It doesn’t matter. It could flood the market with new money. Ben Bernanke has said it himself. The Fed can create inflation just by credibly threatening to print money.

Of course, as has been discussed on previous posts, the Fed could also impose a negative interest rate on excess reserves held at the Fed by the banks. This would essentially force the banks to loan out their excess reserves. After a more than doubling of the monetary base, this in itself would create massive inflation.

It is one thing to predict that the Fed will take a deflationary course, but please don’t listen to anyone who says that the Fed can’t get out of a deflationary situation.

Combining Free Market Economics with Investing