Inflation is a serious problem for investors - because inflation and the policies it evokes can greatly affect the revenue and profits of private and public employers and, thus, their stocks and bonds. It also encourages people to buy gold instead of income-earning assets.
Today, gold prices are high and politicians such as Congressman Paul Ryan, the Chairman of the House Budget Committee, are urging the Federal Reserve to "fight inflation" by not expanding the nation's supply of money with another round of quantitative easing.
Ryan asserts fighting inflation is the Fed's priority. According to Ryan, the Fed's priority is "maintaining our currency as a reliable store of value." That's exactly what the Fed did during the 1930s - and caused 10 years of depression and led to the law specifying that full employment is the Fed's primary goal.
Other Congressmen and the White House are the American version of the UK's "Keynesians" - they want "job bills," subsidies for specific businesses, and more federal spending on shovel-ready projects to end the recession and put people back to work.
So far the "Keynesians" are winning - there have been "jobs bills" and increased federal spending to bail out Detroit and a handful of too-big-to-fail financial institutions. They have also passed tax reductions to encourage spending and induce employers to hire more workers.
The Federal Reserve has stayed on the sidelines. Perhaps because it fears causing inflation from too much spending, the Fed has so far not done much except to assist a handful of too-big-to-fail financial giants and push the overnight rate of interest banks charge each other to borrow reserves for 24 hours to new lows. The Fed's inaction is significant for investors because when the Fed does act, investors will see a great increase in stock prices - the next great bull market and it will have legs.
The investment views of worldly macro economists
Macro economists with real world experience in business and commercial banking are dismayed by Ryan's views, the fears that are causing people to buy gold, and the Fed's continued inertia. And they do not agree that Keynesian fiscal policies are effective in the United States due to its inevitable long lead times compared with Keynes' UK and the political tradeoffs that inevitably neuter its effect.
The worldly Macro economists are particularly appalled by the deficits and unemployment caused by the current recession. They see "quantitative easing" by the Federal Reserve to encourage customer spending as the United States' only available option.
In essence, today's worldly economists are not Keynesians. They do not want more federal spending. They do want employers, both profit and non-profit, to have more revenue from non-governmental spending so they will hire more workers and produce more goods and services and pay more taxes. They deny that more non-governmental spending in today's economy, which is only producing at about 80 percent of capacity, will cause inflation instead of more jobs, more production, more profits, and higher tax collections.
Unfortunately, despite the United States' massive unemployment, business and bank failures, bankruptcies, foreclosures, low tax collections leading to deficits, and a stagnant stock market, the Fed's governors have for four years vacillated about increasing the quantity of money in circulation to stimulate the non-governmental side of the economy (when the Fed finally acts it will be called QE3 but it's really QE1 because the first two were diverted to bank reserves by the FDIC - and so did not actually expand the quantity of money in circulation and the banks' loanable funds).
In essence, the Fed fears inflation will result from too much spending if it increases the money supply - its governors apparently fear inflation, if their monetary expansion overshoots, as worse than the gains that will accrue as business and employment recover and the stock market and tax collections rise.
In other words, because the Fed's governors are afraid they will overshoot and cause inflation, and because they don't realize they have the tools to instantly stop any "overshoot" in its tracks, the Fed's governors are doing nothing - except fiddle around with irrelevant tweaks in the overnight rate of interest while the economy and jobs and tax collections burn.
Investors can find a detailed description of the MANY causes of inflation, including how certain traditional efforts to fight inflation can make it even worse, in the February 20th Seeking Alpha article "Inflation, economic policy, and the best investments for today."
Are the inflation fears of Ryan and the Fed and the gold holders warranted?
No. The Governors' fears of inflation and those of the Congress are based on inaccurate "common knowledge" - beliefs that were long ago discredited by macro economists with real world experience in business and commercial banking. They hold that, as a group, the Fed's governors are making bad decisions because they have inadequate educations and experience in the real world of banking and businesses.
In essence, the governors' unworldly ignorance and personal indecision is hurting investors by devastating the economy. The President and Congress may make speeches and claim they doing something - they aren't and can't except for naming new governors - it's all up to the Fed because the Fed and the Fed alone has the power to act.
Where does the unworldlyness come from?
What Ryan and the Fed's governors apparently believe what is an article of faith in some political quarters, many second tier economics departments, and most central banks - that America's periods of inflation have been caused by too much spending caused by increases in the money supply.
To these people it follows that the only answer to prevent inflation is for the Fed to hold down or reduce the money supply to hold down spending. This is the position of the Fed's current governors and many members of Congress.
This particular bit of "common knowledge" results from the failure of macro economists like me to convey the complexity of our economy to our students who become decision-makers and journalists. In the real world, many things, not just too much spending caused by too much money in circulation, can cause the level of an economy's prices to rise.
The root cause of this failure to deal with our current economic malaise is the failure of our 2nd tier economics departments to adequately train worldly macro economists. They are, instead, turning out model building quasi-mathematicians whose simplistic analyses are vulnerable to the inevitable unexpected "black swans" - the numerous complex real world events and circumstances that lie outside their overly simple models.
In essence, the problem is that many of the inadequately trained students found employment at the Federal Reserve and similar second tier economics departments and rose through their academic bureaucracies and committees to become columnists and Federal Reserve decision makers - and brought their lack of training and unworldliness with them.
In the real world there are many black swans when it comes to inflation and fighting it - because many things can cause a country to have higher prices, not just increases in spending caused by increases in the money supply. So if a person bases his investment decisions or his nation's economic policies on the idea that there is only one cause of inflation, he will, at times, fail to make the most profitable investments and, if he goes to the Federal Reserve, fail to stop inflation or massive unemployment. This appears to be one of those times.
How did the 2nd tier economics departments and policymakers get it wrong?
As someone who spent a lot of years teaching and writing about macroeconomics before I got bored and went into business, I know that untold numbers of students and Federal Reserve employees have studied the relationship between the money supply and prices - and found that the money supply has increased over the past 80 years at the same time the general level of prices increased. Of course they did - the Federal Reserve has increased the amount of money over the years so our economy could handle the increased number of transactions associated with our economy's growth and the higher prices that occurred over the years for various reasons.
But merely finding a relationship does not mean the increased money supply caused the higher price levels or will cause them in the future. It's true an increased money supply will cause inflation by causing excessive spending. But most of our periods of inflation have been the result of other causes.
In other words, because the economy had higher prices the Fed
frequently increased the money supply so business and consumer transactions could continue at the higher prices, not the other way around.
Where has the Fed's macro economic naïveté taken investors?
Today the United States has an extreme shortage of customer spending in relation to our economy's productive capacity. In the real world, public and private employers only hire people and produce goods and services when they have money coming in - customers. Today many consumers find it hard to get consumer credit, many businesses still cannot renew their lines of working capital let alone get financing for new equipment, and many families can't get mortgages even if they are highly qualified, and many governments are cutting back because their tax revenue has fallen (unemployed people and unprofitable businesses don't pay taxes).
So today in the real world businesses, consumers, governments, and foreigners are not buying enough to cause our economy to come even close to reaching full employment and the tax collections that would be associated with it.
In other words, in the real world we are not even close to having inflation caused by too much money and spending. Instead, because our economy is operating far below capacity we have massive unemployment, low tax collections resulting in budget deficits, and businesses with stock prices far below those that would exist if they were as profitable as they would be if our economy was at full employment and growing.
What does this mean for investors?
Sooner or later the White House and Congress will stop making silly speeches and the President will appoint, and the Senate confirm, sufficiently trained and worldly decision-makers for the Fed. Then, and only then, will the United States roar out of its economic malaise and move to a much higher level of profits and stock prices. Only when this happens will there again be prosperity and a major new bull market. In other words, the good intentions and fine speeches and the new laws and "jobs" programs that will be introduced by the White House and Congress in the months ahead don't mean diddly. Only the Fed counts.
And the Fed acting to get the economy going will only occur when it takes either or both of two actions - increasing the loanable funds in our commercial banks or directly channeling newly created money to people such as Social Security recipients.
What absolutely won't work is the Fed changing one of the two interest rates the Fed can actually set - policies which in their unworldly naïveté the Fed's governors think are important and make much of. One of those rates is the overnight rate of interest at which banks borrow and loan reserves for 24 hours - anyone who thinks a banker will borrow money that has to be repaid in 24 hours and will loan it out instead of repaying it is either living in a fantasy world or working at the Federal Reserve or writing a financial column despite never studying macro economics.
The only other rate the Fed sets is the "discount" rate at which a commercial bank can borrow reserves directly from the Fed. Banks rarely do this, and certainly never to get money to loan, because it is a signal to the markets that the bank is in serious trouble and faces imminent collapse.
When should investors make their move?
A new bull market is certain to occur when the Fed finally acts. So investors should watch for speeches and other indications the Federal Reserve is about to finally begin taking the necessary steps to restore the economy to full employment levels of production.
Specifically, optimistic forecasts and announcements of Fed interest rate changes are virtually irrelevant and should be ignored; announcements of quantitative easing or the direct channeling of liquidity to possible spenders are significant - when that happens investors should look for U.S. companies with excess capacity that can quickly and profitably be put back to work as the additional liquidity causes the economy to recover.
Those that come to mind when the upturn starts: machine tools, community and regional banks, for example Huntington Bancshares (HBAN); construction and heavy equipment, such as Pentair (PNR); somewhat upscale restaurant and hotel chains, like Marriott International (MAR); chains of for-profit hospitals such as Community Health Systems (CYH); and pharmaceutical companies with a broad range of drugs, like Eli Lilly (LLY).
In the meantime, despite the continuing stagnation, which I expect to continue for all of 2012, and thereafter until enough of the Fed appointees change, there will be rapid moves of stock prices up and down in response to specific one-time events such as the coming Greek default - so some short-term traders will make money and some will lose.
Finally, a word of caution. Because of the current Fed-induced malaise of the U.S. economy there will be great temptations to invest in gold or stocks and bonds from outside of North America or in funds that do it for you. I don't recommend this unless you are seeking the exceptional rewards that come with exceptional risks - North America is a great place to do business and at its worst it's better for investors than anywhere else in the rest of the world. In other words, going to gold or outside the U.S. and Canada, because of the current economic malaise in the United States, you're quite likely to get burned.