Bonds and Inflation

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There was an article posted today on LRC by Peter Schiff.  Schiff understands Austrian economics and can explain it simply to the average person.  The article talks about Fed inflation, but the most interesting part is near the end when he talks about bonds.

Schiff states: “A confounding factor is the strong performance of US dollar-denominated bonds. When the Fed creates inflation, that erodes the value of fixed-asset investments like bonds, which can’t adjust their returns to the new price level. So many commentators are pointing to the record-low bond yields as evidence that inflation is not a threat. But this is a misreading of the situation.

What is overlooked is that when the Fed prints more dollars, it typically uses them to buy bonds. Traders know this, so they are stocking up on bonds at ridiculous prices just to flip them to the Fed. They don’t care that, in the long run, the Fed’s policies will destroy the bonds’ value because in the short run, the weak dollar policy serves as a tremendous subsidy to bond sellers.”

Schiff is saying that low interest rates don’t mean that there is a low threat of inflation.  The Fed buys bonds when it is inflating, thereby driving down interest rates, at least for a while.  He is certainly right in what he is saying.  I do think that rates will go up quickly, if and when inflation is perceived as a major problem by the general population or even by the investment community.

This subject has been discussed often here before.  I think it is unlikely that we will see gold go to $2,000 an ounce without seeing rates go up.  But Schiff’s point should not be taken lightly because gold may be a warning sign to interest rates.  Perhaps this is what is happening in the latest rise in the gold price.

The point is, don’t wait for interest rates to rise to protect yourself against inflation.  Interest rates and bonds may lag because of the Fed trying to suppress rates.  The Fed may “succeed” for a little while, but it will fail in the end.  Get your inflation protection now.

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