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I know, I know, folks like myself have been worrying about an inflation spike since the fall of Lehman and the introduction of the multiple money pumping initiatives from the Fed, and, so far at least, according to the experts, we've been wrong. First, I'm not incredibly sure we've been that wrong as, for example, energy, food, stock & bond prices as well as college tuition are either excluded from most official calculations of inflation or are a minimal component - and obviously they are all up significantly in the past few years. I'm not saying that we are in a high inflation environment but I believe that inflation is evident in aspects of our economy - contrary to most published reports. That being said, even if we believe that inflation is not an issue right now, I think it is a danger lurking in the future that investors should be aware of.

One of the primary reasons that many commentators have made inflation predictions over the past few years is that the money supply is increasing dramatically due to actions from the Federal Reserve. I've heard some ridiculous arguments that the Fed isn't actually monetizing debt or increasing the money supply, but I believe the below chart (taken from the St. Louis Fed website) will be persuasive.

(click to enlarge)

For background, the supply of money is the amount of monetary assets that are in the economy at any given period of time. As different assets have varying degrees of liquidity, there are different ways to measure the money supply. The most common measurement is M2, which contains checking and saving accounts at banks, money market accounts and CDs (less than $100,000). Increasing the money supply, especially at such an accelerating rate, has historically been feared due to the understanding that money itself (unless tied to a specific tangible asset) doesn't have value other than as an efficient means of transaction. Therefore, more money into the system merely dilutes the purchasing power of all of the other money then in circulation. Thus, putting more money into the system may increase nominal prices (and there are rational, if not always convincing arguments, for why one would want to do that) but the relationship between more money and real increases in economic prosperity - especially for the average person - are highly dubious.

The supply of money is not the entire story, however, and another factor that needs to be considered is the velocity of money. The velocity is the rate at which the money supply turns over during a given period of time. Basically, if the same dollar gets spent twice during a year then the velocity would be 2. Below is a chart showing historical velocity of M2.

(click to enlarge)

From this chart we see that velocity has decreased sharply in the past five or so years. Velocity, as it tells us what people are actually doing with their money, plays a key part in the creation of inflation, and as the below chart shows is highly correlated to interest rates.

(click to enlarge)

Milton Friedman gave his definition of inflation as "too much money chasing after too few goods" and in today's world we see that there may be too much money but it isn't chasing too enthusiastically after goods (few or otherwise). My inflation forecast boils down to an expectation that the money supply will continue to grow rapidly, pushing inflation indices mildly higher, however, at some point, the velocity will increase and cause a sudden jolt of inflation that has the potential to get away from the central planners.

The money supply is increasing due to two factors. The most obvious reason is that the Fed is monetizing debt and pumping it into the system. Looking deeper, however, I believe that the main reason that the Federal Reserve is following its current policies is due to the profligate fiscal policies of the Federal Government.

The Fed is not going to change from its current monetary policy because it can't do so politically. There have been hints and speculations that the Fed would start tapering (reducing the amount of stimulus), speculations which so far have not come to pass, and that I think will continue to be off base (save for a token announcement here and there). According to the Fed, the reason that the QE programs are continuing is that demand is still too soft and unemployment too high, thus stimulative responses are required. That begs the question of what the Fed plans on doing if in a year or two years we are still not near their prescribed economic activity levels. It also is worth asking what the Fed plans on doing if economic activity stays depressed and inflation starts to increase. I think the answer to both of those questions, and realistically the answer regardless of outcome (especially with the likely selection of Janet Yellen to the Fed Chair spot) is that pumping and easy money will continue.

However, in my view, the real reason that the Fed is embarking on its current path and is very unlikely to deviate significantly in the future (and why the money supply will continue to expand rapidly) is due to the ever increasing deficit and correspondingly increasing interest expense. Net interest on the federal debt was about $220 Billion in 2012 and, by my calculations for fiscal year 2013, the Federal Government is on track to spend around $236 Billion on net interest. The first thing is that the official number is bogus because it excludes debt that the government holds itself (I'm sure that having the government not count those liabilities just thrills everyone with a social security account!) and the second thing is that this is what it costs with record low interest rates! By adding interest on the intra-governmental debt I calculate the total 2013 interest to be around $330 Billion. By adjusting the average interest rate that the government would have to pay it is apparent how sensitive (and vulnerable) our government's finances would be to an increase in interest rates. Below is a simple chart depicting today's average interest rate and forecasted annual interest payments should rates increase (again, this doesn't include any principal repayment and doesn't include compounding).

(click to enlarge)

To put the above numbers into perspective, the current interest expense equals approximately 11% of government revenue (taxes). If the rates were to go back up to historical averages then interest on the debt would account for 29% of all revenue - or about $200 Billion more than the government spends on defense. So, all of that is a long way of saying that if the Fed cuts back on its purchases of government securities, the prices for those securities will decrease and interest rates will thus increase - increasing (potentially a great deal) the interest expense on the federal debt. With all of the acrimony in Washington right now over government spending, one thing nobody wants is to pay more money in interest. So, despite what the experts say, don't expect a slowdown in the Fed's operations.

So with the money supply course appearing relatively set, the real question is what happens to the velocity of money. For starters a low velocity indicates that the economy is not healthy as consumers and businesses hold onto funds and are afraid to spend. This is unusual after a recession and I'll let the reader draw their own conclusions as to why things are the way they are. Nevertheless, with the administration and the Fed openly decrying the risk of deflation and openly pondering even more stimulus, one wonders whether they may attempt to push the velocity button. Traditional understanding is that the Fed and the government don't have too many good options to impact velocity, short of changing interest rates to encourage or discourage borrowing and raising and lowering taxes. With rates already at or near zero and with the administration calling for higher tax rates, not lower, those policy solutions appear unlikely. However, in the context of the Fed worrying about deflation and the administration worrying about a sluggish economy as it heads into the next election, anything is possible.

So, what could the Fed or the government do to try and impact velocity? I believe the Fed is more limited, but the administration and its associated federal agencies could potentially pull a few levers. The most likely scenario I see is that the government, through its various regulatory bodies, works with the banks to "encourage" more lending. Many of the banks are on the receiving end of very lucrative business deals with the Fed and may be willing to play a little ball to keep the easy money and bond/asset deals coming. There is also the possibility that the government could institute an expatriation holiday or various other more free market measures (not referred to as tax breaks to appease their base) that would encourage business to spend.

Even if the government does not push to influence velocity, I believe that natural market forces (however restrained by various governmental restrictions) will eventually be turned loose again. The primary reason for this isn't necessarily that businesses and individuals are going to be in a better financial situation than they are in currently, although they may be slightly improved, but I think that at some point that the fundamental improvements that we are beginning to see in the real estate market and in large corporate earnings will spread to other areas of the economy. I also think that the build-up in cash that corporations have been accumulating (to the tune of almost $2 Trillion in the US) will likely decelerate - and it is even possible that the cash on corporate balance sheets will decline as corporations find different ways to use their resources (i.e. M&A, dividends, share buybacks, capital expenditures, etc.) rather than holding treasuries or keeping cash in demand deposit accounts.

As consumer spending increases and as businesses put their capital to use, at some point the economy and the velocity of money will begin to increase more rapidly. At that time as individuals and businesses begin to exit the pessimism and denial phases and begin to act as they are no longer in recession, the inflation rate will likely shoot up dramatically as velocity reverts to its historical mean. As this happens investors long the market will benefit. Unfortunately, I believe that the rate of inflation is very likely to break away from the rate of growth in the economy and accelerate. As the acceleration happens there will be different strategies needed.

To hedge or to take advantage of high inflation there are many commentators out there pushing gold or silver. I do not believe that commodities are a good investment unless it has a practical use. If inflation takes off the government will have a few options. One option would be to reduce the value of real services provided (easier to do in an inflationary environment) and use the additional tax revenue to pay down the debt to a manageable level. The Fed could then raise rates and work to manage the inflation similar to what Volcker did in the early 1980's (although on a larger scale). In this scenario there would likely be a deep recession and some social unrest but after an adjustment and some structural changes moving forward the country would be in a decent spot. If this is what occurs then gold and silver, possibly in ETFs such as SPDR Gold Shares (GLD) and iShares Silver Trust (SLV), would be a good hedge.

However, if inflation gets out of control and if the government decides it will tackle it through price controls, rationing, or through additional Keynesian stimulus programs then quality of life and the social fabric of the country will likely be severely strained. In that type of environment gold and silver will be of less value and more practical assets would be preferred. If this were to occur physical assets such as food, weapons and shelter would be the best things to invest in - both physically and in entities that specialize in those businesses. Likely beneficiaries (or at least companies that would hold some real value) would be Sturm, Ruger & Co. (RGR) and Smith & Wesson Holding Company (SWHC).

Source: The Worrying U.S. Path Toward High Inflation