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Inflation and How it Might Affect You

Due to current government spending policies, the fastest growing deficit in history and an administration that is printing money out-of-nowhere in an attempt to keep artificial asset prices (housing bubble) inflated, there is a real possibility that we may enter a period of severe price inflation. Some respected economists, such as Mark Faber, PhD, are even concerned that hyperinflation similar to Zimbabwe’s fiscal catastrophe are not only possible, but assured.

If the U.S. enters a prolonged period of inflation, as was felt during the term of President Jimmy Carter (1977-1981), what will it mean to the average citizen. That may well depend on how well you have prepared your assets and finances for the possibility.

Inflation occurs when an increase of prices on goods and services across a broad section of the economy is experienced. In plain English, everything costs more.

The price we pay for goods and services can be driven up from two basic sources – supply or demand. If the inflationary pressure is supply-side, prices are being driven upward by an increase in labor costs (wages, benefits, etc) or by the rising costs of raw materials. If inflation is caused by the demand side of the curve, it’s simply that more-and-more people want goods and there are not enough to go around.

We hear a lot about how monetary policy can cause or ease inflation, but with the explanation above, how is that so?

To cause inflation, one thing that can happen is too much money is put into the economy. The United States operates on a fractional reserve system. Basically, it means that a bank can can loan out $100.00 for every $10.00 that it actually has in its reserves. That’s how money gets created. To over-simplify a bit, banks borrow $10.00 from the central bank, then loan out $100.00 backed by that $10.00. $90.00 just came out of nowhere. That’s added liquidity or adding money to the money supply.

Typically the Federal Reserve will lower rates to pump liquidity into the market. This makes money cheaper to loan/borrow so more borrowing happens which puts more money into the marketplace to buy goods and services.

Once interest rates get at or near 0% and the economy is not growing, extreme measures are sometimes taken. Quantitative easing is just such an extreme tactic. The Fed can no longer lower interest rates, so they start creating money out of thin air. Sometimes called “printing money”, it’s actually done by creating credit in the central banks own accounts (from nothing), and using those non-backed assets to purchase paper (bonds, loans, etc) from other banks – now those banks have the money from nothing.

Seems harmless, right? Why can’t we all just credit our accounts with money from nothing and use that to buy whatever we want? We can’t do that because it would lead to inflation – a lot of it. As more money is created, each existing dollar becomes worth less and less. If a dollar became worth half it’s current value, the face value would still be $1.00, but it would only purchase 50 cents worth of goods. You would then need two dollars to purchase that soda that cost a buck prior to the free-for-all printing fest.

So what should we do? The best course of action is of course to get the government to stop “printing” money, but with the debt loads the United States is taking on and is planning on bearing, there is not much likelihood that it will stop any time soon. Next, we as individuals would do what we can to protect our own assets and finances.

There are varying theories that run the gamut from hoarding precious metals to getting a gun and living in the woods. I think there are some things we should be doing to prevent last-ditch tactics like those from being necessary.

First, own hard goods. Things that have value and you own outright. That’s a house without a mortgage, cars without loans, land, real estate.

Some would argue that having debt is perfect for inflation as the debt would require less money to service. Hogwash, you’ll be paying so much for gas and groceries that you’ll still not be able to pay those reduced-value debts. Then you lose your house, cars, land… all those hard goods that would have been better to own during inflationary times.

While gold is a hard asset, I have one basic concern with owning gold as a hedge to inflation. If gold becomes a better currency than paper money, the government could do what it has done in the past – take it from you. In 1933 President Roosevelt forced citizens to sell all of their gold at a price that had not adjusted for inflation (roughly $21.00/ounce), once the government had all of the gold, they re-adjusted it for inflation and deemed it worth $35.00/ounce. Gold did not function well as a hedge in that case, and I believe a liberal government would do the same thing again to increase the money supply if all else had failed (which it would have if we were relying on gold as currency).

Let’s say the government doesn’t make owning gold illegal (again). If you owned a few plots of land or houses as assets (no liability against them), someone with a lot of gold might purchase them from you – and now you would have the amount of gold (or dollars in a more realistic case) equal to the inflation-adjusted worth of your property. The difference being, you bought the land with pre-inflation dollars and are selling the land once the currency has normalized. This makes sure that you come out of an inflationary period with the same or better net-worth than you went in with.

Second, get into securities that invest in commodities. Exchange-traded funds (ETFs) that concentrate on commodities simplifies this play. As inflation makes those commodities rise in price, your investment should reflect that change. This is not a cure-all, be wary of what commodities your actually investing in. Gold looks to be severely over-priced and if the price begins to drop, the Chinese will do what they always do – dump, dump and dump.

There are also inflation-protected bonds available from the treasury known as TIPS. These securities are designed to protect investors from inflation. Not only do you benefit from the bond yield, but your base investment will adjust for inflation. These investments do not fair as well in normal times due to lower yields, but in a pro-longed inflationary period, this is a good play.

So with inflation, horde assets and protect your net worth.

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