A Study of Inflation

"The first panacea for a mismanaged nation is inflation of the currency, the second is war.  Both bring a temporary prosperity; both bring a permanent ruin.  But both are the refuge of political and economic opportunists." - Ernest Hemingway

The United States, Europe and Japan are all reporting low inflationary numbers.  In fact Europe is trying to fend off Japan style deflation while the United States considers inflation benign at 1.5%.  The average consumer can argue all day long that the inflation rate is accelerating as the cost of everything from food to gasoline to insurance to health care to school fees to ... I could go on and on but you get the picture.  Furthermore stock markets around the world have produced double digit returns for the past number of years and assets such as housing, art, diamonds and other exotic style investments are seeing prices never before witnessed.  So why is there such a dichotomy between what the Federal Reserve reports and what is really happening in the world and how could this affect the investment landscape in the years to come?

The problem is that the measure used by the Federal Reserve to calculate increases in prices excludes the increase in asset prices and strips out oil and food price spikes.  So when the stock market rallies or house prices increase or the cost of a diamond soars, these price increases are not added to the inflation gauge used at the central bank.  Back in time inflation was calculated by determining the amount of money that was added to the market relative to a quantity of gold.  Adding more money meant that the value of the currency would decline unless more gold was added to the reserves.  Devaluing the currency resulted in things costing more per dollar and thus inflation was calculated.  When the world left the gold standard and printed money at will this valuation metric was dropped and a new measure of price increases was used.

In a way this was understandable as the complexity of new financial products made it very difficult to operate on a standard as simple as the gold standard but the increased complexity has brought with it the problem that it is impossible to calculate the actual money supply or the total currency in circulation and therefore there is no way to accurately calculate inflation.  For this reason the Federal Reserve and central bankers around the world use some form of price increases to estimate the inflation rate.  In the United States added complexities are put into the equation like the perceived benefits associated with technological and medical advances.  These benefits are handled through adjustments to the actual numbers.  So what you really have is a concocted number (I can see them brewing up the next one in their laboratories now) rather than a real understanding of inflation and this is why the central bankers of the world are continually caught with their pants down when their readings finally register inflation.

So how much have currencies depreciated (or inflation increased) over time.  Well if you take one metric which is to compare the value of a dollar to the price of gold, a dollar purchased 1/250th of an ounce of gold in 2000 and today it buys 1/1,300th of an ounce.  This equates to an inflation rate of over 500% during that time frame.  Another metric is to Look at the Federal Reserve balance sheet which has expanded from $800 billion to $4 trillion in five years.  This equates to an inflation rate of 500% in five years rather than 14 years calculated using gold.  Either way you can quickly get the idea that the expansionary policies followed by the central bankers of the world have decimated the currency and pushed inflation into orbit, all the while reporting modest to no inflation. In the past when inflation has run amok like this trouble brews and so it is imperative that you find investments that will protect you.

As I mentioned earlier the authorities will not act on an inflationary signal until it appears in their data.  Until that point in time they will continue with their inflationary programs thinking that they can quickly deal with the problem.  This has never happened in the past because as we have seen they are not monitoring the real inflation rate, so the chances of them catching it early this time have already passed.  Fortunately they are slowly reducing the monthly buy but it is too little too late as normal.

In an inflationary environment like the one we had here in the 70's it is imperative to own assets, and by assets I mean hard assets like real estate, gold, oil, diamonds and the like.  Stocks do not normally perform well as their value is based on a future cash flow stream and if that stream of cash is seen to devalue due to high inflation they can often lag the appreciation of real assets.  So look at your portfolio and ensure that you have some allocation to these investments as the sooner you do the better off you will be when the Federal Reserve finally wakes up to what you and I already know.