Tuesday, April 6, 2010

Inflation Denial Won't Keep Prices Low

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.

Denial is one of the most destructive forms of behavior for investors. While the markets can operate on false scenarios for a significant period of time, reality always wins in the end. When it does, the situation can get quite ugly and all the profits gained from a belief in an unsupportable viewpoint can evaporate over night. At the moment, there is a lot of denial about inflation and investors should be paying attention to this.

The case for inflation is based on common sense and the laws of simple arithmetic. A country cannot create money at a faster rate than its economy is growing. If this occurs, the currency is devalued and it then takes more units of currency to purchase any given item (which is the same as saying prices go up).  There is a time lag between these two events however, sometimes many years, so people frequently don't connect them. Indeed, governments who engage in this behavior frequently go to great lengths to insure the public doesn't make the connection and realize that inflation is caused by government actions. Invariably throughout history, speculators and foreigners are blamed for rising prices. Think about whether or not you've heard any talk about speculators lately. There will be a lot more of that in the future.

When it comes to inflation, governments not only try to act like magicians and dazzle you with one hand while picking your pocket with the other, but they also engage in strong and persistent denial of its existence. Any number of fanciful, but easily debunked, arguments will be produced to show inflation doesn't and even can't exist. In Weimar Germany in the early 1920s, the economic establishment engaged in an across the board denial that inflation existed and there were even 'proofs' created to show that there was really deflation. Inflation eventually reached the hundred trillion percent level there.

So what is happening in the U.S. today? At the March 16th FOMC meeting, the Fed stated "With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.” The implication is of course inflation can't exist if there is substantial resource slack. By the rules of logic, if we can find a single example that contradicts this, we cannot rely on this statement. There are of course many, many such examples. The most recent and perhaps extreme is what just took place in Zimbabwe. The unemployment rate there reached 94% (yes that's unemployment) and the economy essentially experienced a total collapse. According to U.S. Fed, there should have been massive deflation in Zimbabwe, instead of the second worse case of hyperinflation in world history. How could this have happened? Zimbabwe printed a lot of money. The U.S. has also been engaged in significant excess money printing during the last two years.

The evidence of inflation is also not likely to show up first in U.S. government reports. The government has a vested interest in making sure that it doesn't. This is part of managing inflation expectations, which the Fed also mentioned in its statement. The last thing the government wants is for people to be aware of coming inflation and they will manipulate the official numbers and the news as much as necessary to keep this from happening. Investors who want to know what is really going on with inflation need to look elsewhere for the facts. The most recent ISM (Institute of Supply Management) reports indicated very strong inflation pressures in the system, particularly in the manufacturing sector. This story got buried in the media though and was covered up with glowing claims for economic recovery.

Investors should also watch the markets for what they are saying about inflation. There are three important indicators - interest rates, oil and gold. U.S. treasury interest rates have been bubbling up for awhile now. The market is having trouble absorbing the huge supply of bonds that the U.S. has to sell in order to fund the budget deficit. Long-term interest rates have broken a 30-year downtrend line and look like they will be heading higher for many years to come. Oil just broke above a nine-month trading range and is now heading higher as well. Nothing has more of an impact in leading to higher consumer inflation than does rising oil prices (which are set internationally and are out of the Fed's control). Gold has risen from a low just above $250 in 2001 to its recent high in December above 1200. It is in a seasonally weak period at the moment, but should be hitting new all-time highs in the fall.

Inflation provides an object lesson of how investors need to approach the markets. The media is filled with information on financial topics, and much of that information is misinformation. It is necessary to cut out or ignore the irrelevant to make good investing decisions. The best way to do this is think for yourself, believe your own experience, and watch what the markets are actually doing.

Disclosure: Long oil.

NEXT: An Analysis of Retail Sales Media Coverage

Daryl Montgomery
Organizer, New York Investing meetup

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

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