The stock market went down significantly today, a day after the Fed announced that it would rollover some of its previous purchases to buy government bonds.  The market decided a day later that it wasn’t all that good of news.  Of course, the stock market investors really wants to hear something more drastic from the Fed and they aren’t getting it right now.

Until the Fed announces something significant (like forcing banks to lend excess reserves), then we will likely continue to see stagnation or worse.  It looks like the only thing that will send stocks straight up at this point is some massive money injections (which we obviously don’t want).  Unemployment remains high and interest rates remain low.  People are scared and rightly so.  The government has created massive malinvestments in the economy and it isn’t letting the problem fix itself.  As long as the government continues to spend like crazy and bail out failed businesses, the economy cannot flush out all of the bad investment.

The Federal Reserve met today and announced that it would spend a relatively small amount of money buying more government debt.  The Fed is not sounding as optimistic as it did a couple of months ago.  After the announcement, the stock market recovered some of its losses and the interest rates on bonds went down further.  You can now get a 30 year fixed-rate mortgage for 4.5% or less.

While this announcement was not insignificant and it certainly symbolizes that the Fed is still worried about the economy, it was not a drastic move.  A drastic move would have been an announcement that the Fed would start forcing banks to lend their excess reserves.

This whole thing goes to show that hyperinflation will probably not happen.  The word hyperinflation is thrown around casually quite a bit these days.  Hyperinflation basically means the destruction of a currency.  In our modern world, with a high division of labor, hyperinflation could mean death and destruction if there are no competing forms of money at the time (as is the case now because of legal tender laws).

The Fed and the people working there may be stupid, but they aren’t that stupid.  They could force the banks to lend and all of this talk about deflation would go out the window.  We would see massive inflation in a short period of time.  The Fed is not ready to go there yet and it may never go there.  While the Fed tries to accommodate the politicians and the bankers, it probably will not risk destroying the currency.  If the Fed destroys the currency, it destroys itself along with it.

Prediction:  The Fed will inflate and we will see high price inflation, but just like the late 70’s and early 80’s, the Fed will tighten up and let interest rates rise.  We will see a worse recession/depression than the early 80’s.  We will not see hyperinflation.

If the above prediction is wrong and we do get hyperinflation, then the people at the Fed really are that stupid and we will all pay for it dearly.

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?

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.

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.

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.

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.

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.