Yesterday, the Fed reduced the overnight federal funds rate to 1% and the discount rate to 1.25%. There’s not much more room for rate reductions before the Fed needs to take more drastic actions to make credit available.
The Fed and the Treasury are determined and they will do whatever necessary to avoid deflation, short of paying people’s mortgages for them. Bernanke made this clear in his now famous speech from 2002:
I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States and, moreover, that the U.S. central bank, in cooperation with other parts of the government as needed, has sufficient policy instruments to ensure that any deflation that might occur would be both mild and brief. …
The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.
But is creating more dollars the same thing as creating more money, thus avoiding deflation? Will the Fed actually be able to generate higher spending and positive inflation as Bernanke says?
To answer this, we need to understand what money actually is. Modern money is credit, meaning a promise to pay a certain value as denominated in a currency. So how do we measure the amount of money in circulation? Should we determine the amount of credit money based on the nominal amount of currency, or based on the value of goods and services promised? A real measure of money would have to use the latter. In this case, if creating more dollars does not result in an increase in the amount of credit as determined by value in goods and services, then more money has not actually been created.
So it is possible that printing more dollars will not have the desired effect of creating more money and thus reflating the economy. It will just create more dollars which will be hoarded or used to pay off debt.
Real inflation is caused not only by the amount of money in existence, but also by its velocity, which is how quickly it moves from one person to the next. To get inflation, you need to get people to spend the new money and then to borrow more. You also need people willing to produce and sell things in exchange for this money.
In hyperinflation, nobody wants to hold onto money because they fear that it will be worth less tomorrow so they spend what they have as soon as they get it. This feeds on itself with increasing price rises causing increasing inflation expectations causing increasing velocity which causes prices to increase again, and so on. In deflation this works in the opposite way, and both cycles can be difficult to stop once they get going.
In the present economy people are less able and less willing to borrow and spend money into existence. So, to cause inflation, the Fed needs to replace the borrowing and spending “efforts” of hundreds of millions of people.
It’s not clear that Ben Bernanke’s printing press will be able to accomplish this before it destroys the value of the dollar. If the dollar stops having value as money, then it doesn’t matter how many trillion dollars you print into existence.
We live in a global economy where the dollar isn’t the only meaningful measure of value. We need to import from other countries and we need to pay the value of the goods we import, not a set nominal number of dollars. If people around the world feel that they will not be able to get something for dollars, they will eventually stop accepting them for their own goods, regardless of all the political reasons to take dollars.
The Fed can’t print money, it can only print dollars. For now this is essentially the same thing, but it doesn’t need to be.
How should we invest in this kind of environment? We are in uncharted waters, so there is no tried and true solution for how to profit from all this, but protecting your capital is the most important thing. You need to be able to preserve the value of your savings before you can make them grow. In the present environment it’s hard to see how to do either, but here are some defensive investments that make sense now:
- Government issued inflation linked bonds such as TIPS in the U.S or the equivalent in other countries. We hope that the interest makes up for the amount the government understates inflation, so we at least break even. There is an ETF with the symbol TIP that invests in these, or you can buy them directly from the U.S. Treasury here.
- Gold and silver have been a good store of value over the long term, though they can be very volatile in the short term. They can’t be printed and they can’t default, so they will always be worth something. GLD and SLV are ETFs that invest in gold and silver bullion respectively, though there are many other ways to invest in precious metals.
- Basic consumer products that will be consumed in any economic environment. Food is the most obvious of these. Here we want companies with recognized brands that give them some pricing power. Look for shares with dividends because they help support the share price and provide some income. Heinz (HNZ), General Mills (GIS) and Kraft (KFT) are some examples.
When the dust settles there will clearly be some excellent investment opportunities in many sectors, but you need to preserve your capital in order to take advantage of them.
Disclosure: The author is invested in gold, silver and inflation linked securities. He has no positions in the companies mentioned.