Frank Shostak has written a piece for the Mises Institute on price inflation.  He is predicting that price inflation will pick up this year.  He makes the assertion that “it takes about 36 months before changes in the money supply generate a visible effect on the prices of goods in general.”  This would mean that the Fed’s more than doubling of the monetary base in late 2008 and 2009 would only begin to show up this year.

Whether you agree with this or not, there are certainly a lot of arguments in favor of higher price inflation in the somewhat near future.  The monetary base has gone up like never before and even though much of this new money is sitting at the banks as excess reserves, there is that looming threat that it will be released and massive price inflation will hit.

The most fascinating thing right now is that price inflation is making a lot of headline news, even in the mainstream media.  CNBC has had several segments talking about inflation in the little bit of time I have watched it.  I have also seen stories on popular financial websites talking about inflation.  I will also see the occasional opinion article saying that deflation is actually our biggest threat, but even this is insinuating that most people are viewing inflation as the bigger threat (despite what Bernanke says).

Normally I would be a contrarian and believe the opposite of what the mainstream media is saying, but in this case my contrarian view is that even though many are predicting an uptick in price inflation, I don’t think they understand just how bad it could get.

If the banks start to loan out those excess reserves, prices could move higher very quickly.  In addition, the velocity of money or the speed at which money changes hands will play a big role.  Velocity has been low as Americans are fearful of the future and have been trying to save more and spend less.  If people start to perceive that prices will continue to move much higher in the near future, then it gives an incentive to buy “things” right away before losing purchasing power.  This drives prices even higher and can be a bad cycle.

At that point, the Fed will have to slam on the monetary brakes or risk hyperinflation.  I am reasonably sure that the Fed will stop creating money and allow interest rates to rise (a lot).  Then we will experience a very harsh depression and DC will be forced to cut back severely (which won’t be depressing at all).

Get your investment ducks in a row now.  Make sure that you are ready for high price inflation.  Make sure that if price inflation hits 20%, that your investments will do well enough to keep pace.  This means that you must have some investments (such as energy and precious metals) that will do really well in a time of double digit price inflation.  And do not count on wages keeping pace with inflation, at least in the near term.

The short answer is no.  And it doesn’t matter how we define inflation.  In Austrian economics, inflation is an increase in the money supply.  Obviously higher oil prices can’t cause an increase in the money supply.

The definition of inflation used commonly today refers to an increase in the general price level.  While there can be a correlation between higher oil prices and price inflation, oil prices do not cause a general increase in the price level.

Higher oil prices can cause certain prices to go up.  One obvious example is gasoline.  Even though consumers ultimately determine prices, higher oil prices do increase the cost of gasoline, which is generally passed on to the consumer.  Higher oil prices could cause other certain things to rise.  If a certain item costs a lot to be shipped, perhaps the increase in transportation costs could affect the price of the item.

But we are talking about a general rise in prices.  If anything, higher oil prices would have the opposite effect.  Let’s say that you have a family budget of $2,000 per month.  Part of that budget is gasoline and you have $100 per month budgeted just for that.  Now let’s say that gas prices double.  Most of your driving is necessary (commuting, going to the store) and you can’t cut down on it.  Therefore, you now have to budget $200 per month.  This means you will have to cut $100 from somewhere else.  Perhaps it would be eating out at restaurants or some other form of entertainment.  No matter what, you will be spending $100 per month less on something else and this will actually drive other prices down.

The only way for you not to cut spending somewhere else is for your budget to increase.  For this to happen, you need an increase in the amount of money you have.

Now take this example and translate it to the entire economy.  If oil (and hence gasoline) prices go up, most Americans will cut somewhere else, thus driving other prices down.  The only way that all or most prices can go up with oil and gas is if you have more money in the system to bid up prices.  Therefore, we would need monetary inflation to drive up the overall general price level along with the price of oil.  This is ignoring the short-term effects in changes of velocity or the speed at which money changes hands.

Therefore, if oil prices go up without an increase in the money supply, it is likely that some other prices will fall.  This is a classic case of why the definition of inflation has changed over time.  If inflation was defined as an increase in the money supply, then everyone would know to blame the Fed for higher prices.  Instead, when inflation is defined as higher prices, we get to hear hacks blame everyone but the Fed and government.  They will blame China, greedy businessmen, or whoever else is convenient at the time.  Of course, they will also blame higher oil prices, which is obviously ridiculous based on what is written above.

Oil prices do not cause inflation.  Inflation (an increase in the money supply) causes higher oil prices.  Other things can cause higher oil prices like supply and demand or the perception of a coming change in the supply and demand.  If we see higher oil prices and a general rise in other prices, we can be sure to blame the money creators at the Federal Reserve.

There is a lot going on right now.  The protests are spreading in the Middle East.  The latest big news with protests is coming from Libya, where the thug dictator is not going down easily.  This in turn has caused the price of oil to spike.

Silver is hitting 30-year highs and gold is near all-time highs.  Food prices are going up just about everywhere.  Meanwhile, there have been a couple of bad days for Wall Street.  In addition, housing prices are hitting new lows (although this is good news for buyers) as more and more people are underwater with their mortgages.

Today there was news of Charles Plosser, president of the Federal Reserve Bank of Philadelphia, saying that he may push for an early end to QE2 (money creation).  Whether or not QE2 ends early does not matter much in the long-term.  Eventually the Fed will be faced with a choice and that choice may have to be made sooner than expected.

Although Bernanke gets a lot of attention as the Fed chairman, he really is just one man.  His views may not matter quite as much as some think.  The Fed is part of the establishment.  But they are their own sector.  It is a group of elitist bankers.  The establishment matters more than one man (Bernanke).  In the same way, the presidency is part of the establishment.  The president doesn’t really matter all that much, as long as he plays the game.  The last one who didn’t play the game was Kennedy and we know how that ended.

So basically, it is not just Bernanke’s decision on what happens.  It is really up to the banking establishment.  This is why I don’t think we will have hyperinflation.  We may have massive price inflation, well into double digits, but I don’t think the bankers are going to go Zimbabwe style on us and risk their own fortunes.

The Fed will face a decision when price inflation gets higher and there is pressure from foreign nations.  Paul Volcker is not some wizard, but the Fed pulled back when he was chairman.  This saved the dollar and the economy.  There was some short-term pain in the recession of 1981/1982.  I think the same thing will happen again (with a much bigger recession), regardless of Bernanke.

The Fed will be under pressure by Congress, and maybe the president, to monetize debt.  The Fed will only play the game for so long.  If there is a high risk of hyperinflation and a total collapse of the dollar, the Fed and the bankers will save themselves.  They will not risk a total breakdown of civilization.  They have too much invested.  In addition, there will be much pressure from other countries, blaming global problems on the U.S. central bank.

The Fed will stick it to Congress.  The problem and decisions will then be forced on the federal government.  They will have decisions to make as to what will be cut.  I think the empire will be the first major thing to go.  Americans would rather choose Medicare and Social Security than Iraq and Afghanistan.  If it is really bad, there might not be a choice as everything would get cut.

The biggest bubble has not been tech stocks or real estate.  The biggest bubble is government at all levels.  The bust is coming.  It will hit state and local governments first.  Then it will be the federal government’s turn to go bust.

The union protests in Wisconsin are an interesting sight to see.  While the eventual result of what happens in Wisconsin has little effect on our daily lives, it is symbolic of what is to come.  There are a lot of states in financial trouble and government pensions are near the top of the list of expenses.

First, it is important to point out the libertarian position in all of this.  Libertarians believe in the separation of school and state.  People should not be forced to go to school or send their kids to school.  In addition, people should not be forced to fund schools, whether they have kids or not.

As far as unions, libertarians believe that people should be free to associate with others.  If a bunch of employees want to get together to negotiate with their employer, that should be their right to do so.  At the same time, it should be the employer’s right to fire anyone they want.

So basically, in a libertarian world, while unions would not be outlawed, they probably wouldn’t exist without the support of government.  In addition, while I am not against a bunch of people pooling their money together and running “government schools”, in a libertarian world, government schools probably wouldn’t exist because money would have to be collected voluntarily.

For this debate, let’s accept the fact that there are government schools and teachers.  If the government is going to provide pensions for government school teachers, it should be a defined contribution plan.  In other words, they should have the equivalent of a 401k.  If you are going to force taxpayers to pay for teacher pensions, then it should at least be limited to current taxpayers.  Governments should not be making promises based on the ability of future taxpayers.

This whole thing in Wisconsin will be repeated in states all over.  During the boom times, taxpayers did not fight the government pensions and salaries.  Now that the middle class is struggling, people are getting tired of the parasites.  Government salaries and benefits are now far higher on average than other workers.  People are starting to revolt and this is just the beginning.

There will continue to be fights all over the place.  The government workers and unions will win some fights, but I think they will lose in the long-run.  The average Joe outnumbers the government employees and the average Joe is starting to wake up.

Eventually this will move to a federal level.  Most of this will happen in local and state governments first because they can not run huge deficits.  They are more limited in their spending, whereas the federal government has the Federal Reserve to buy its debt (print money).  Even this is limited by the threat of hyperinflation, but Washington DC can kick the can down the road for a bit longer.

Oil prices were up huge today.  The price of crude went up about $8.  This is a major jump when the price isn’t even at $100 yet.  The main reason for the big jump was because of continuing protests in the Middle East, particularly in Libya this time.

There are reports now that long-time dictator, Gaddafi (there are about a million ways to spell this guy’s name), has fled Libya.  This has spooked the oil markets due to fears of an interruption in supplies.

From a liberty standpoint, these protests are a good thing.  They won’t produce some libertarian paradise overnight for sure.  And we know that democracy can be just as bad as dictatorships at times.  But despite what you might hear from hacks like Sean Hannity, these protests are not mainly about religion or ethnicity.  They are mostly about oppressed people seeking some freedom.  And they are not like the protests out of Greece or Wisconsin with people demanding more government handouts.  There may be some of that in these Arab states, but it is mostly about people wanting the grip on them loosened.

Russia is a corrupt place in many ways and there are certainly more desirable places to do business.  But not many people would deny that Russia is a better place to live than 25 years ago when it was the Soviet Union.  Freedom does not usually come all at once.  Just like socialism progresses with baby steps, sometimes it is the same for freedom.  So overall, these protests are a good thing as people seek a taste of freedom that they’ve never had, but maybe heard about.

With all of that said, these protests could be a short-term disruption for business.  Along with oil prices, gold and silver prices went up significantly today too.  This is not to say that they couldn’t all fall back down tomorrow, but we can’t ignore these huge moves.  Libya produces some oil, but it is no Saudi Arabia.  If protests start to flare up against the Saudi dictators, then the oil market could really get spooked. We could see the price of oil go to $150 or even $200 in a very short period of time.  Gas prices will not be far behind.

It might not be a bad insurance policy right now to have a few oil plays in your investment portfolio.  Just the price of gas alone will get expensive if something major happens.  There are ETFs, individual stocks, and mutual funds that can be bought to get exposure to the price of oil.  If you buy individual stocks, I would recommend that you stick with the big companies.

The other interesting thing we will watch in the future is how this may affect velocity.  The velocity (the speed at which money changes hands) has been low in the U.S. since the fall of 2008.  If velocity picks up because of these events (or any other reason, like QE2), then high price inflation could be closer than people think.

The price of silver is at a 30-year high.  One ounce of silver is now trading over $32.  The only reason it is not at an all-time high is because of its brief rise to almost $50 back in 1980.  That brief explosion in silver prices occurred when the Hunt brothers tried to corner the silver market.  It also happened during a time of high inflation and right about the time that Paul Volcker slammed on the monetary brakes.

I am a fan of silver related investments only up to a point.  As we can see from 1980, the price of silver can go down just as quickly as it can go up.  Silver is far more volatile than gold.  For this reason, I suggest that you invest a far higher proportion of your money into gold related investments than silver.

Silver may have a place in your portfolio, but it should be a small place.  I wouldn’t recommend more than 5%, or maybe 10% if you are really aggressive.  It is a good speculation because there is such a high upside potential.  If gold goes to $2,000 per ounce in the next year or two, silver could easily go to $75 per ounce or more.  This is not a prediction, but just an observation that silver is a higher risk and reward play than gold.

If you are good at timing the market (almost nobody is), then silver is a stronger play.  If you invest in it as a speculation, try to be disciplined and take some profits if and when the price goes up.  You will never know exactly when it will reach its top, just like any other investment.  It is important not to get too greedy and to take profits on the way up.  It doesn’t mean you have to sell all of it at once.  Actually, it is a good idea if you don’t.

Again, I am talking about silver and silver related investments here as a speculation.  It should not be part of your permanent portfolio.  For Harry Browne’s permanent portfolio, the gold portion will be your protection against inflation and a crashing dollar.  Gold is far more stable than silver and I expect it to continue that way.

The adjusted monetary base is on fire.  A couple of months ago, I was starting to doubt whether QE2 was actually happening as it wasn’t showing up in the monetary base.  Well, the February 17, 2011 update of the monetary base shows a line straight up since the beginning of the year.  It is obvious now that the Fed is actually doing what it said it would do.  QE2, otherwise known as the Fed buying government bonds, otherwise known as money creation, is happening.

You can view the chart here:
http://research.stlouisfed.org/publications/usfd/page3.pdf

We will closely follow the excess reserves held by commercial banks over the next few months.  We want to see if this increase in the monetary base is at least somewhat sterilized by an increase in excess reserves.  Bernanke claimed that the Fed was not increasing the money supply in circulation.  Either he expects all of this new money to go into excess reserves or he is lying.

If even part of this new money gets into circulation through the banks, then price inflation should be close at hand.  I think prices could explode at any time.  It is hard to say what will lead the way.  Commodities and precious metals could be the leaders.  Stocks might keep doing well, but that is harder to say.  When consumer prices start going up at a good clip, you can count on food prices to rise significantly.

We may be coming up on one of those rare investment opportunities.  Although high inflation won’t really be good for anyone, we can at least try to profit from some of it, or at least protect what we have.  If the excess reserves don’t keep pace with QE2, I think all of our speculative investments belong in hard assets.  The dollar will get crushed and price inflation will take off.  Hard assets like gold, silver, platinum, oil, food, and maybe even real estate will do well.  You can’t make these things on a printing press.

For anyone that studies the money supply, it can be quite confusing.  There are different measures of the money supply and you can read or listen to three different people come to completely different conclusions, based on different measures of the money supply.

Robert Murphy has written a piece that gives a good summary of what makes up some of these different money supply measurements.  It certainly can be confusing on what measurements you use and what you should use them for.

First, a big reason for looking at the money supply in the first place is because we want to predict price inflation.  The only problem is, there are so many variables.  There are different measures of the money supply, but there are other factors too.  There are excess reserves held by banks, there are loans, and there is the velocity of money or the speed at which money is changing hands.  These all have an effect on prices.  In addition, an inflation in the money supply may show up in asset prices like stocks or commodities while not showing up in consumer prices.

With that said, we still want to have a useful measure of the money supply.  My personal favorite is the monetary base.  The reason I focus on this measure is because it is the measure that is most directly controlled by the Fed.  For example, with QE2, you will see the Fed’s buying of bonds show up in the monetary base.  The Fed can buy or sell assets and change the monetary base.

Now that banks are piling up excess reserves, we have to pay attention to this too.  But overall, the monetary base tells us what the Fed is doing.  It can’t tell us with any certainty what is going to happen with price inflation or the stock market or commodities, but neither can any of the other measurements.  At least the monetary base can accurately tell us what the Fed is doing and can at least provide us with that little piece of the puzzle.  Right now, it is telling us to watch out for rough waters ahead and to buy gold.

I am subscriber to Harry Browne’s permanent portfolio.  With all of the uncertainty in the world, it is good to have some of your investments safe and sound, or at least as safe as possible.  The permanent portfolio is set up to weather any type of financial storm and it has done its job well.

With that said, I think it is ok to speculate with a portion of your money, as long as you can afford to lose it.  Right now, I think the best speculations (in my opinion) are in non-dollar assets.  The federal government (along with state and local governments) is piled high in debt with no end in sight.  The only solution coming out of DC is more money creation.  This is bearish for the U.S. dollar.

For your permanent portfolio, your gold portion should be in assets that correlate directly to the price of gold.  You can actually buy the metal in coin form, you can buy certificates that are redeemable in gold, and you can buy an ETF (symbol: GLD).  However, for your speculative investments, gold stocks are a more interesting play.  There is more leverage and more risk.  But the rewards can also be far greater.

An interesting exchange traded fund (ETF) that you might want to look at is GDXJ.  It is made up of junior mining stocks.  It is a good way to get some exposure to this sector.  It is a risky sector as many junior mining companies never really get off the ground and make a profit.  But they can also be very profitable.  This ETF is a way to get exposure to junior mining stocks while also spreading your risk around.

This is an investment that could easily go down 50% or more in a stock market or gold market downturn.  On the other hand, if gold goes up 20%, you could easily see this ETF more than double.  The good thing about it as a speculation is that you can liquidate it quickly.  It trades just like a stock and you can buy it with almost any online brokerage account.  When you are ready to take profits, you can sell it in minutes or less.

Again, you should not mix this with your permanent portfolio.  This is a speculative investment as a play against the U.S. dollar and for gold.  You can review GDXJ here.

There are budget battles going on in Washington DC.  Republicans in the House have proposed up to $100 billion in cuts.  Obama has proposed cutting $1.1 trillion from the deficit.  This would be decent if it weren’t for the fact that the $1.1 trillion in cuts would be over 10 years.  This calculates out to just over $100 billion per year.

The Republican cuts are a real joke.  They are playing games with the numbers, counting things as cuts from future spending increases.  Even if these were real cuts, they are still a joke.  The deficit for this year alone is expected to top $1.5 trillion.  Therefore, a cut of $100 billion isn’t even 10% of this amount.  And don’t forget that this is just the deficit.

So even if Obama and the Republicans came up with $100 billion in cuts, it means we might have a deficit of $1.4 trillion next year.  This means another $1.4 trillion added to the national debt, which is already sky high.

The Republicans could propose cuts in all sorts of programs.  They could scrap the Education Department. They could get rid of all subsidies to farmers.  They could end all foreign aid.  These would be easy things.  In fact, they don’t just have to propose cuts, they can actually do it.  They hold control of the purse strings.  The president can only sign what is put on his desk.  If the Republicans never pass a budget with these things, then they will automatically be gone.  The same goes for Obamacare.

Aside from the easy things that won’t even happen, the only way to balance the budget is to look at military spending and so-called entitlement spending (Medicare, Medicaid and Social Security are the big ones).  There is no will to touch any of these things.

So what does this whole thing mean for the big picture?  It means the federal government is heading over a cliff at a high speed.  Maybe they can stop the car from accelerating.  Maybe they can even slow it down by one M.P.H.  But unless they slam on the brakes right now, this car is going off the cliff.  This means some kind of default.  It will mean painful defaults for people that will be counting on Medicare and Social Security.  It will mean high inflation.  It may mean an outright default on bonds.

All of your speculative investments should be counting on a weaker U.S. dollar for the long-term.  The politicians in DC are guaranteeing this outcome.  The Fed will go along until it faces hyperinflation.