Inflation is coming our way. Make no mistake about it.
This insidious increase in the general level of prices is currently rattling around in the world's emerging markets - causing China and Brazil to put up interest rates and India to try and suppress it with price controls. It's beginning to appear in Britain, which had a similar crash to the United States, but where the currency has been somewhat weaker.
Within the next six months - while the U.S. Federal Reserve is still buying U.S. Treasury bonds under its "quantitative easing" policy - this inflation tsunami will hit the United States.
Inflation is a lot like the unwelcome houseguest: Once you invite it into your home, you can't seem to get it to leave.
The key catalysts for the inflationary visitor that's headed our way are the silly-money policies that the Fed and other central banks have been pursuing. Those policies have inflated yet another massive bubble - this one in the commodities sector. All the cheap money that's right now sloshing around the global markets have sent commodity prices into the stratosphere, and are causing emerging-market economies to grow like crazy.
Inflation was especially virulent in the 1970s, when rising prices and high unemployment combined to cause the particularly odious form known as "stagflation." It certainly didn't help that it took policymakers almost the entire decade to face up to the fact that inflation wouldn't go away on its own.
Indeed, it wasn't until we got Paul A. Volcker in as Fed chairman in 1979 that inflation even had a worthy foe. It was Volcker who eventually crafted the aggressive policies that were required to vanquish the inflationary pressures that had gripped the U.S. economy for so long.
This time around, unfortunately, the U.S. central bank appears to be even more determined to ignore inflation's early warning signs, while the banks and the politicians will fiercely resist higher interest rates, the only known remedy, because of the dangers of a further housing collapse.
So we can expect inflation to be with us for several years this time, too. In fact, expect it to get worse for the next three to four years, while Ben S. Bernanke remains at the helm of the nation's central bank. Bernanke's term as Fed chairman ends in January 2014; hopefully, whoever is the U.S. president at that point won't reappoint him.
But we'd better arrange matters so we don't lose out from it.
A Tale of Caution
As investors, the main problem we have with inflation is that any contract written in nominal dollars will rapidly decline in value. Long-term bonds are the classic losers from periods of inflation; their nominal value declines, and their prices decline, as well, because inflation pushes up interest rates.
My Great-aunt Nan, a splendid lady, retired at 65 in 1947 - at the beginning of Britain's postwar inflationary surge, with ample retirement savings - invested in a 3.5% War Loan, the normal safe haven for British savers in the 19th and early 20th centuries.
She made it into the 1970s, bless her. But by the time she died, not only was the income from her War Loan worth a quarter of its 1947 value, but its capital value had also declined in nominal terms to about 30% of its 1947 level, as interest rates had risen from 3½% to 12%.
(Little wonder the British newspaper, The Independent, once wrote that "over the years ... the War Loan is a monument to the poor investment value of government stocks.")
Don't let this happen to you!
The One Move to Make Now
If your money is in bonds - whether those bonds are U.S. Treasuries, municipals or corporates - move it somewhere else.
If you have the sort of solid final-service pension that companies used to give out and the government still does, check the inflation protection. If the pension doesn't have a 100% protection against inflation - however high it goes - you have a problem.
In the face of rampant inflation, many stocks won't be an answer, either. Theoretically, if your company is making tangible things from tangible factories, or providing tangible services (and not just sitting on a bunch of loans and bonds), then its earnings (and therefore its overall value) should rise with prices. In practice, however, this often doesn't happen.
For one thing, many institutional investors use the so-called "Fed Rule" for determining share price values, which divides the expected future earnings stream by the current interest rate (Future Earnings Stream/Current Interest Rates = Share Price Value).
That's why stocks behaved so spectacularly in 1982-2000: As interest rates came down the "denominator" of that value equation got smaller and smaller - which made it easy for the share price value to go up.
But there's a problem: That formula uses "nominal" - not "real" - interest rates. It also fails to account for cuckoo Fed policies, so if interest rates are exceptionally low for a long period, the formula says share prices should go up and up. And if the interest rate is close to zero, the share "value" should be close to infinity!
With the return of inflation, nominal rates will have to increase to keep pace. And real interest rates will have to do the same as Volcker-esque monetary policies are used to get inflation under control. So share prices will almost certainly decline sharply in real terms, just as they did from 1966-82, even though nominal share prices remained approximately flat.
Gold and silver are a good speculation in times of inflation, but not a good investment. Before 1914, when the world was on the "gold standard," the gold market was approximately in equilibrium at a price of just under $19 per ounce. U.S. consumer prices have increased 22-fold since then, so a price of $418 per ounce today would be fully justified. You see the problem?
In practice, the increase in world population - by about 3.7 times - since 1914 should have caused the gold price to increase approximately in tandem. That's because the world's gold supplies have not increased, but its population has. That would justify a price of around $1,550 today.
This calculation suggests gold is a good buy currently, but if inflation returns and money stays cheap, the price of gold is going to be far above that level quite soon, and buying gold will have become a very speculative activity. At $3,000 per ounce, gold is a hugely risky investment.
What's the best investment to make right now? A house.
The housing market has bottomed out - or, at worst, is close to doing so. And you can get a fabulous rate on a 30-year mortgage, making you benefit from inflation just as bondholders lose from it.
The combination of a relatively depressed housing market and cheap money is uniquely favorable, so you should take advantage of it. For the best investment, you can narrow the recommendation further:
- Don't buy around Washington: The market has been pushed up by the flood of bureaucrats and lobbyists that have taken up residence inside the Beltway - an influx that will reverse itself as the U.S. budget is finally brought under control.
- Don't buy in Manhattan or the Hamptons: Prices have been pushed up by all the silly money sloshing about in financial services, which will disappear with higher interest rates.
- Don't buy in Silicon Valley: That advice holds true there, and anywhere else where local wealth has been inflated by stock options.
- Do buy in a medium-sized town: Make sure that town is in an area where the economy is not dependent on finance, the government or energy/commodities.
- Do buy an old house, instead of a new house: Buy an old rather than a new house - the supply of old houses is fixed, whereas new McMansions will appear in profusion and flood the market while interest rates remain low (developers all have large land banks they want to develop.)
- Do take a 30-year fixed-rate mortgage: In a time of inflation and low interest rates, a long-term, fixed-rate mortgage is a gift from above.
- Don't overextend yourself financially: There could be big recessions in the next few years, so you need to be able to make the payments without selling the house.
- Do be prepared to rent, rather than sell: If you have to move in the next few years, become a landlord and rent the house out instead of selling it outright. Rents have been pretty well flat in the last 10 years; they are likely to beat inflation in the next 10 years, since higher interest rates tend to push rents higher.
Readers often wonder if we follow our own advice. Money Morning has a very good rule, which says that I should not deal in any stocks that I recommend to you. But in this case, I'm happy to be able to report that I am practicing what I preach - I'm taking advantage of the current climate to relocate ... and am in the process of buying a house!
Here's the problem: The longer you work, the more you can save - and the longer the rampant inflation we're expecting will have to work on your nest egg.
But here's the solution: Boost your rates of return.
That's actually just as easy as it sounds. You just have to have the right strategy - and the right investments. And as a subscriber to The Money Map Report, our monthly affiliate, you can count on getting both. Find out by clicking here to read a report that details this strategy.]
News and Related Story Links:
- Wikipedia:
Inflation. - Money Morning News Archive:
Quantitative Easing News Stories. - Money Morning News Analysis:
Zero Job Growth: Low Rates and High Deficits Aren't Helping U.S. Workers. - About.com (Economics):
Stagflation in the 1970s. - Wikipedia:
Paul A. Volcker. - The Independent:
Money: Chasing the yield on War Loan and PIBS. - Investopedia:
Real Interest Rates. - Investopedia:
Nominal Interest Rates. - Wikinvest:
Gold Standard.
Awesome article! 1982 to 2000 also coincided with the Secular Bull market for stocks at that time. In essense, your article basically explains the basis for the secular bulls and bears! Great!
Please respond to the following question. I understand that housing prices have come down and interest rates are historically low but houses still are not selling well. It would seem that if interest rates go up the price of the house would have to go down or else the monthly payment would be too high to be affordable. I bought my first house in 1982 and was 'lucky" to get a 30 year 12% fixed at the time. Home prices did not increase until the interests fell.
What is your opinion?
Thank you
Mark
gold is already highly speculative since present consumption, physic gold owners,
is less than gold futures, etf?, etc.Has never been the case in the past.
Production of gold is limited and goldmines must have a breakeven point in cost
to mining.
Silver is different?Large consumption and production sufficient capacity to i crease.
So these metals have been highly speculative and high volatility.
Please give me your comments and what about inflation in view of speculation
Rob Hilekes
Good suggestions.
I agree that inflation will continue and ultimately force higher interest rates.
I wonder how high this market will go, is it about to drop?
Thank you for such a store of relevant information.
I especially respect the articals by Martin Hutchison, and Dr. Kent Moors. Their wealth of experience and long term wisdom shines through their writings like a beaken of light. I find that so refreshing in this pump and dump arena so populated with con-men.
Best Regards
W.E. Ramer
no where to run
buy a house?
so you can pay the soon to be huge taxes as municipalities raise them
to pay for their huge funding problems
of course you meant the suburbs, since inner city is a loosing bet
so you can pay for gas at the soon to be $5-$10/gal.
no place to hide
I own a house in Washington DC that I am currently renting for 33% above the monthly mortgage payment. I bought the house in 2004 with a 7-year ARM and refinanced in 2009 with a 30-year fixed 4.75% loan. I currently have about 35-40% equity in the house at today's prices.
After reading your article, I'm not sure if I should sell the house when the current lease expires in June or continue to rent? I agree with your projections that the Washington area will see "downsizing" as the budget crisis is resolved and this could mean falling house prices for the area but, Washington being Washington, a new group of players usually replaces the previous group thereby maintaining the status quo in some respects.
I would greatly appreciate if you have time for a brief response to my inquiry.
Sincerely,
A Former Bureaucrat
I see your point on Gold, but I don't understand your coupling it with silver. It would seem to me that silver is an excellent investment going into a potential inflationary cycle. Am i missing something?
Thanks,
Steve
Good article, thank you. But are you right? We have been warned about inflation for the last two years and yet there hasn't really been any to speak of. There is just soooo much debt to pay off. And as long as house prices are declining – they still are – and the money supply stagnates or declines, there won't be much inflation, unless the currency collapses, which is very unlikely. There's still an even chance of the opposite, deflation.
For the late 70s inflation: metals & oils also increased in tendem with inflation until interest rate really jumped up. Can you look inot buying Real return bonds now? If inflation goes up, the bond will
pay more & move up in value. Double action possibility?
Regards
Oh I am sure Martin Hutchinson is right about oncoming inflation, and perhaps even the metaphor is not exagerated. And by all means buy a house when no one wants them and their cost is way less than constructing a new one.
The wise man Hutchinson does not mentionTreasury Inflation-Protected Securities when he sweeps all bonds into the dustbin (domestic Tsunami). Or, in Canada, Real Return Bonds like XRB.TSX?
And don't buy houses in Canada until their prices collapse as in the USA.
Correct my misspelling of "exaggerated," please.
gh
Martin,
Your advise to "buy a house" is right on. This is very much like the 73-75 time and then the inflation aterwards…and a little bit like 93-4. Stock market dumped and in the time afterwards, the real estate market rose. And because we have had two major dumps in the stock market and real estate market, and interest rates are low; the real estate contraction makes this period a great time to look towards rental housing a good investment…right after buying your own residence first.
Thanks for the thoughts. T Davis
Oil has been ignored.Is it because gulf was destroyed by oil?China needs more oil.Usa not so much cause we can not afford gas anyway.New cars running on electric-maybe not.
Hi George:
Thanks for taking the time to write and comment. Martin has written about — and recommended — TIPS on numerous other occasions. Indeed, here's a link to one such story:
http://moneymorning.com/2010/06/09/inflation-5/
Hope that helps.
William Patalon III
Executive Editor
Money Morning
Robin, W.E., Tom, Martin and Satyenedra:
Thanks for your comments. I will personally pass them along to Martin.
Respectfully yours;
William Patalon III
Executive Editor
Money Morning
Mark Lustfield is right. There are waves of homes that are still coming onto the market. I disagree with the author, US housing is generally not a good investment yet, and with interest rates set to rise with lots of inventory on the shelf, it will get cheaper yet.
I also do NOT like TOPS as the government games the CPI numbers. Best inflation hedges are the oil companies, ExxonMobil, Conoco, ChevronTexaco. They pay rock-solid & growing dividends while you wait, and their assets in the ground keepyou ahead of inflation. XLE is a reasonable alternative.
HI All. I am an economic newbie which just recently came in too a few hundred $K from selling a business. I have been furiously reading on how to wisely spend/invest in a new house. I need to purchase a house for my family and thought I would buy "as much as I can afford" with the low interest rates ($200K down on a $500K house new construction). That would leave me with a manageable mortgage payment for me at 3.7% 30 yr fixed. The more I read, the more I wonder if I should sacrifice on the primary residence a bit (older 350K with maybe $100K down) so I can pay off quicker, and purchase an investment property or two with 20% down on each. I just don't want to be foolish and any advice is appreciated. Is a $500K house foolish assuming I have no other investments and my monthly income will be about $80K/yr via a 9 to 5?