Is the U.S. Federal Reserve Setting the Stage for Hyperinflation?

The U.S. government wants to stimulate growth in the moribund economy by stoking the fires of inflation. But by leaving interest rates low and buying up bonds - a policy known as quantitative easing (QE) - the U.S. Federal Reserve risks debasing the dollar, which could lead to a prolonged period of hyperinflation that would send prices skyrocketing.

After their most recent meeting on Sept. 21, Fed policymakers said low inflation warranted looser monetary policy. Minutes from the meeting said central bankers were prepared to ease policy to boost inflation expectations "before long."

The Fed is seeking ways to boost the U.S. economy after keeping interest rates at record lows and buying in $1.7 trillion of U.S. securities. The next move may be another round of quantitative easing that would expand the Fed's balance sheet even further.

But as it feeds more and more money into the financial system, the central bank may very well be sowing the seeds of hyperinflation.

[mm-toolbar] By bailing out big banks with the $700 billion Troubled Asset Relief Program (TARP), pursuing a $787 stimulus program to boost the economy, and launching a near $1 trillion rescue of government backed housing authorities, the government has racked up about $12.7 trillion in debt guarantees and spending.

Without enough hard assets - like gold - in storage to back those guarantees, the only way the government can meet its debt obligations is to print more money.

Money Morning Contributing Editor Martin Hutchinson thinks there's a chance the government could swamp the economy with stimulus and spark a round of hyperinflation.

"With the Fed pumping all that cash into the system, deficits of $1.3 trillion and additional QE of $1 trillion on the table, the odds are getting greater all the time that a bout of hyperinflation could be in the cards," Hutchinson said in an interview.

Hyperinflation can be simply defined as very high inflation, a condition in which prices increase rapidly as a currency loses its value. It usually occurs when monetary and fiscal authorities of a nation issue large quantities of money to pay for a large stream of government expenditures.

In numbers, hyperinflation could mean anything from a 100% cumulative inflation rate over three years to inflation exceeding 50% a month. For example, an inflation rate of 100% a month would reduce the value of a $20 bill to $2.50 in four months.

Hyperinflation can also be viewed as a form of taxation. The most serious consequence of hyperinflation is the reallocation of wealth. It transfers wealth from the general public, which holds money, to the government, which issues money.

Hyperinflation has occurred on several occasions in history. The most commonly known examples are:

• Germany or the Weimar Republic went through its worst inflation in 1923. The highest currency issued was a 100,000,000,000,000 Mark note, which was the equivalent of about 25 U.S. dollars. The rate of inflation peaked at 346% per month, meaning prices doubled every two days. The main cause is believed to be the "London ultimatum" in May 1921, which demanded reparations in gold or foreign currency to be paid in annual installments of 2 billion gold marks plus 26% of the value of Germany's exports.
• On July 22, 2008, the value of the Zimbabwe dollar had fallen to approximately 688 billion per U.S. dollar. After the country's independence, inflation was stable until Robert Mugabe began a program of land reforms that primarily focused on taking land from white farmers and redistributing those properties and assets to black farmers. Rampant hyperinflation ensued when this policy sent food production and revenues from exports of food plummeting.
• Hyperinflation in post World War II Hungary may be the highest on record. In April 1946, prices zoomed higher by 195% every day, meaning they doubled every 15.6 hours. The war caused enormous costs and, later, even higher losses to the relatively small and open Hungarian economy. The national bank was practically under government control. The government spent more than it could raise in taxes and the central bank printed more paper money to finance the deficit.

But even though our economy shows some of these same symptoms, it doesn't mean hyperinflation is a foregone conclusion. Hutchinson says the Fed may be able to balance interest rates to keep runaway inflation in check.

"If prices only go up say 3-4% over a course of a year, the Fed can probably keep it in check with a gradual increase in interest rates," Hutchinson says. "But the problem with inflation is it tends to take off very quickly. If you get a 20% bubble in prices in a few short months, the Fed would have a hard time reacting quickly enough."

Investors can identify hyperinflation before it arrives by watching for a few reliable signs:

• Hoarding (people will try to get rid of cash before it is devalued, by hoarding food and other commodities creating shortages of the hoarded objects).
• Distortion of relative prices.
• People prefer to keep their wealth in non-monetary assets or in a relatively stable foreign currency.
• People regard monetary amounts not in terms of the local currency but in terms of a relatively stable foreign currency. Prices may be quoted in that foreign currency.
• Sales and purchases on credit take place at prices that compensate for the expected loss of purchasing power during the credit period.

So how do investors protect themselves from a bout of hyperinflation and the demise of their purchasing power?

Until government officials reverse their free-spending ways, Hutchinson says hard assets like commodities - such as gold, silver, and platinum - and the companies that mine them are the best bets. But seeking protection in those sectors can get tricky because even a bubble in hard assets will eventually burst.

"As hyperinflation becomes more and more apparent, prices for hard assets will also increase rapidly," Hutchinson says. "But investors will have to be especially nimble to avoid the ride back down. Even precious metals like gold and silver will eventually top out."