This week I am starting a series of blogs on inflation and deflation and what are good / bad investments for those conditions. This week will be focused on inflation and hyperinflation.
Definition of inflation from Yahoo Education: “A persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money, caused by an increase in available currency and credit beyond the proportion of available goods and services.”
Definition of hyperinflation from Yahoo Education: “Extremely high monetary inflation.”
Definition of deflation from Yahoo Education: “A persistent decrease in the level of consumer prices or a persistent increase in the purchasing power of money because of a reduction in available currency and credit.”
Inflation is caused by the following:
1. Money supply grows faster than the rate of potential output of the economy, or real GDP. This, combined with low interest rates, can eventually lead to unsustainable levels of growth as cheap money is available. In the long term this will cause inflation. The Fed will increase the money supply because they are lenders of the last resort. If the federal deficit keeps increasing and there are not enough buyers of the debt (or if the Fed wants to keep interest rates low), the Fed will need to buy the debt by printing more money and adding it to the money supply.
2. Rise in production cost of goods. For example, increases in raw materials and / or increases in labor cost.
3. Change in availability of supplies. The Arab Oil embargo of the mid 1970s is a classic example of change in availability of supply. This caused an increase in the price of gas, paint, and petroleum based products. This was one of the major causes of the mid 70s to early 80s inflation period.
4. The consumer demands more goods and services than are available. This can lead to the seller increasing the price of the good or service and driving up inflation.
5. Inflation can be artificially created through a circular demand by workers to increase wages (for example, when a change in supply increases cost of goods) which causes an increase in production costs which will increase prices that will lead to further demands of higher wages. You do not want to be on a fixed income when this happens.
The main cause of hyperinflation is the Fed printing money at a much faster rate than the growth of GNP. A great example of this is post World War I Germany.
The best investments for inflation or hyperinflation are the following:
1. Commodities, precious metals or gold (see blogs Gold – January 3, 2010 and Natural Gas – February 8, 2010). You could use Mutual Funds, Exchange Traded Funds (ETF) or commodity producing and / or mining company stocks for investment in commodities, precious metals or gold.
2. Real estate. This could include personal or income property (with a fixed rate mortgage) or Real Estate Investment Trust (REITS). In Germany during the post World War I period of hyperinflation, a home owner could not find his banker to pay off his mortgage because he could have paid it off with one day of salary. You want to own a lot of leveraged assets when there is hyperinflation.
3. Foreign stock or currencies of countries which do not have inflation or hyperinflation. For example, if the BRIC countries (Brazil, Russia, India, and China) do not have inflation or hyperinflation you could use BRIC ETFs for foreign stock investing (see blog BRIC ETFs … - January 13, 2010).
4. Very short term CD or Treasury securities if you need cash for future investments or for cash flow.
5. Shorting US currency and US treasury or long term bonds (if interest rates also increase) (see blog … Shorting US Treasuries - January 13, 2010).
The worst investments for inflation or hyperinflation are the following:
1. Investments in cash. For example, CDs, saving accounts, etc.
2. Long or medium maturity duration bonds (see blog Bonds – February 27, 2010).
3. Long term fixed rate annuities or anything that pays a fixed income.
Next week, I will write about what causes deflation and investments for deflation.
Future topics may include:
- What investments will be good investments with rising inflation and interest rates?
- Prediction when we will have inflation or deflation
- Warning signs of inflation or deflation
- Shorting US currencies
- What sector will do the best in 2010?
- Update on performance of blog trades
- Financial rules / lessons (school of hard knocks)
- Other topics
In April I will be starting a financial website (www.paulsgang.com) and in the summer I will be kicking off a financial podcast with Fullstacks, Mr. C and C4.
Please add your insight. For example, when will the US have inflation or deflation?
I would like to have an on-going discussion of financial and investing ideas.
© 2010 Paul Cusick
Paul
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These are nice bullet lists of points seldom to be found in such clarity on the Internet. I'm looking foward to your opinion of whether it'll be (price) deflation or inflation - I believe there's no denying we have monetary inflation in any case. My take on the matter: Looming Deflation?.
ReplyDeleteHey
ReplyDeleteYou can think of inflation coming in two main forms
1) DEMAND-PULL:
a) government spending exceeds tax revenues
b) wages increase faster than productivity
----- won't happen with current unemployment
2) COST-PUSH: Cost of goods rising
(Commodities )
I believe we are in the beginning of Demand-pull cause by the government. On the plus side demand pulled inflation is limited to a single country or area. In this case reallocating some of your investments to foreign countries would be a good choice. Sooner or later, your home currency will depreciate relative to foreign currencies. The BRIC country mention in the article would be a good play. The foreign investments should as compare to the USA currency rise.,
Commodities would also be a good choice I would stick with the soft Commodities think sugar,wheat,coffee... not Gold,copper ....
My reasoning for this is china is the biggest player in the Commodities market and they have over 70 Billion square feet under construction. 40 billion or so for office space enough room for a 5 by 5 cube for the entire population of china. There need for more copper steel ... should be falling off. Food on the other hand
Another cause of inflation is the weakening currency the cycle works as follows
The currency deteriorates, now it's more expensive to import goods and services from other countries, fueling inflation. The government responds by raising interest rates.
If the above would happen we would be hearing on the news how our trade deficit is falling this would be reported as a good thing.
Hum we have been hearing this
Who remembers the '70s, the combination of rising interest rates and inflation would be a devastating economically.
The weakening dollar also help in the inflation game by making the cost of goods rise for USA. But at the same time since good are trading in DOLLARS and other currency would be comparably worth more as measure in DOLLARS they would not see the increase in commodities prices.
Making matters worse China doesn't let its currency float. By doing this China gets to enjoy the economic boost that a cheap currency can bring.
Another blog topic may be Stagflation a nasty little devil
Fullstack