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You've heard the call for several years:

"INFLATION IS COMING! INFLATION IS COMING!"

The more extreme predictions out there were calling for hyperinflation as far back as 2008 and 2009. Here we are, three years later, and inflation is still very subdued. All the talk about money-printing at the Fed and the most we could squeeze out was your run-of-the-mill 2% inflation.

It's not that the "inflationistas", as we'll call them, were wrong about everything. They merely failed to take into account how extreme the contraction had been and how difficult it would be to counteract the massive deflationary tug of the market. The Federal Reserve, try as it may, simply does not have much power to create "inflation" in a massive balance sheet recession, once it's already resorted to a zero interest rate policy. Yet, just because the inflationistas were wrong in 2009, doesn't mean that we shouldn't be worried about inflation in 2013. From the data I'm seeing, the risks for inflation are starting to rise significantly.

At this point, the market has become accustomed to a low-inflation environment, and we seem to be embracing 2% bond yields as the "new normal." This pattern may very well end soon and the most compelling reason why inflation might be around the corner can be summed up most accurately in one chart:

(click to enlarge)

That's the US Federal budget deficit as a percentage of GDP for the past 112 years. As you can see, there are two gigantic spikes on the chart: one for World War I and another for World War II. Then, you can see a third, somewhat smaller spike that began around 2008 and that has lasted to the present day. That's where we are now.

You can also see that there was significant inflation with the last two spikes, when you chart CPI alongside the budget deficit.

(click to enlarge)

The other spike in inflation came in the 1970's through the early 1980's, and may have been caused by a combination of poor fiscal, monetary, and political policies. But no matter how you look at it, fiscal excesses have traditionally created inflation. We haven't seen it yet primarily because of the extreme depth of the contraction of 2008 and 2009; but we're in 2012 now and it's a different environment.

What About Japan?

We've often heard the US's "Great Recession" compared to Japan's "Lost Decade." Japan (EWJ) has run massive fiscal deficits and has been in a perpetual state of monetary easing, yet has seen subdued inflation. But there are major differences between Japan's "Lost Decade" and the US's current predicament.

For starters, let's not forget just how huge Japan's asset bubble was. Real estate prices in central Tokyo actually rose nearly 600% in a few years during the Japanese Asset Bubble. While the US housing bubble was big, it simply was not on nearly as grand of a scale as Japan's bubble.

Another big difference: demographics. Japan went from a rapidly growing population to virtually zero growth. This dramatically changed the dynamics in Japan and has resulted in subdued demand for real estate; which in turn lowers the demand for loans, keeping interest rates and money growth low, as well.

Even if you disagree with me on the differences, however, there are a few stats that are difficult to ignore. For starters, it's somewhat of a myth that Japan began stimulating the economy almost immediately. Rather, Japan didn't start down its path of perpetual stimulus until several years after the collapse of the bubble in 1989. Indeed, Japan was running budget surpluses from 1989 to 1993.

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Of course, you can see that eventually, Japan entered into a state of perpetually large budget deficits. It's been there for about 17 years now. Yet, there's something else going on. Maybe it's the demographics. Maybe it has something to do with currencies. Maybe there's another explanation, but Japan's M2 money supply growth has actually been quite subdued in spite of these deficits.

In 2010, Paul Kasriel of SafeHaven penned an article about Japan's two lost decades. There's one particular chart that stands out to me in Kasriel's article. It's the first chart showcasing GDP growth vs. growth of M2 money supply. While Kasriel uses a 10-year average for M2, we can clearly see that the trend has been downward. In the early 1990's, Japan rolling 10-year M2 growth average was around 10%. By 1995, it had fallen to 6%. By 2000, it fell all the way to around 2.5%. Not much changed in the 00's, as the average M2 growth rate ranged from 2% to 3%.

Whatever you believe about Japan's lost decades, it's difficult to deny that M2 money supply tells a story of subdued inflation. And as we will soon see, this is not the case in the United States.

M2 Money Supply

Let's take a look at historical M2 money supply figures for the US. While it makes sense logically that inflation would be related to M2 money supply, there are enough other factors to make things a bit complicated. The chart below shows M2 money supply alongside of CPI inflation.

(click to enlarge)

We can see from this graph that CPI seems to closely follow M2 on some occasions. M2 exceeded CPI for most of the early 60's. CPI hovered in the 1% - 2% range for those years, before spiking up to 3.8% in 1966, and then it quickly pushed all the way to 6.2% by 1969.

At that point, M2 contracted again, before making an even more dramatic series of spikes in the 1970's. Once again, CPI lagged a bit, but eventually pushed all the way to 12% in 1974. Once inflation spiked, M2 contracted (due to tighter monetary policy), before spiking again in the mid to late 70's. That spike was followed by another huge round of inflation that peaked in 1980 around 13.6%.

After that point, there was another brief spike in M2, but inflation began a steady decline regardless. M2 eventually followed.

The Housing Bubble and Flawed CPI Measures

The data gets even more interesting after that. The US begins another series of spiking M2 money supply figures around 1998 and 1999. Inflation does not appear to follow. Or does it? Actually, this is what I would argue is one of the great failures of American economic policy.

In 1982, housing prices were removed from CPI inflation and replaced with a concept called "owners' equivalent rent." The differences between the two figures are not that dramatic from 1982 until the late 90's, but around 1998, they begin to drift very far apart. This is important because housing is probably the #1 place for inflation to manifest itself.

(click to enlarge)

A year ago, I created an Alternative CPI measure to try to account for this discrepancy. Essentially, my measure is exactly the same as the CPI measure currently used, except I replaced Owners' Equivalent Rent with the Case-Shiller 10-City Index. Unfortunately, it's impossible to go back to 1982 with this methodology since Case-Shiller was not started until 1987. But we can replace CPI with my "Alternative CPI" from 1988 onward to see how that changes our M2 vs. CPI chart.

(click to enlarge)

The reason I love this chart so much is because it shows us something very dramatic that the prior chart completely missed. Whereas, our previous chart suggested that the spikes in M2 in the late 90's and early 00's only resulted in moderate inflation, this chart suggests that in actuality, the 00's were very similar to the 1970's in terms of inflation.

M2 spikes all the way to 8.5% in 1998, which is followed by a spike up to 7.0% in the Alternative CPI inflation index in January 2001. This is followed by an even more dramatic jump in M2; it hits 10.3% at the end of 2001. By 2004, our Alternative CPI index shows steady inflation over 8% from May 2004 till March 2006, peaking at 9.8% in September 2005.

There's only one more big spike in M2 before the most recent one. This jump occurred in late 2008 and early 2009 as the Federal Reserve and Congress took dramatic steps to try to stem the financial crisis. M2 spiked to 10.3% by January 2009.

The Alternative CPI index shows extreme deflation at that time, with a -8.1% inflation rate in December 2008. Even in spite of that significant deflation, it only took about 18 months for inflation to catapult all the way to 3.8% in May 2010. It's true that 3% - 4% inflation was not something to worry much about at the time; but the bigger point is how rapidly monetary easing and large fiscal deficits were able to reverse a dramatic trend towards severe deflation.

The underlying theme here is that spikes in M2 almost always lead to spikes in real inflation.

The 2012 M2 Spike

This brings us to our latest spike in M2. Below you can see M2 money supply from 2011 to the present time.

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And now we can measure it on a year-over-year basis. I decided to go back one more year for this chart.

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As you can see, we've been hovering around 8% - 11% since around July 2011. We've shown how, in the past, these dramatic spikes in M2 have almost always resulted in significant inflation down the line. However, there has tended to be a lag of somewhere between 12 - 36 months before this takes place. For this reason, I view inflationary risks as being elevated in 2013, 2014, and 2015.

Improvement in the Housing Sector

It's also important to look at how things have been improving in the housing sector. Thirteen months ago, I argued that housing would rebound stronger than expected. This wasn't that aggressive of a proposition to me, since the market practically expected a 10-year depression at that point. When I penned that article, my largest holding, Pulte Homes (PHM), sold at $3.91 per share. 13 months later, it sells at $16.13. It's clear from this that the market believes that a housing recovery is now underway.

The evidence at least partially substantiates this. The chart below shows the gradual improvement in housing starts over the past 15 months.

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New building permits were at 811,000 on an annualized basis during July; a 30% increase year-over-year. This suggests we'll see even more improvement in residential construction in the upcoming months. And this thing could have a long way to go, when you examine the broader historical outlook, which still shows us at historically depressed levels of construction.

(click to enlarge)

My estimate of a normalized environment is about 1.5 million starts per year, so we're only about halfway there right now. But this recovery in housing, combined with the rapid increases in M2, suggest something particularly frightening to me. That a mere 6 years after the last housing bubble started to pop, we could be re-igniting a new one.

The $6.7 Trillion Stimulus, Inflation, and the 2012 Elections

This brings me to the elections. Basically, all the data I'm showing you suggests that we might see a burst of inflation in the next 12-24 months. Contrary to popular opinion, I view Congress and the President (both Bush and Obama) as the primary culprits here, rather than the Federal Reserve. (However, recent events may change that; we'll get to that in a bit.)

It's a bit of a myth that we've had one stimulus package. In actuality, we've had a continuous series of stimulus packages. Since the United States is a sovereign issuer of its own currency, we do not have "debt" in the traditional sense of the word. Rather, when we run fiscal deficits, we create more money, and hence inflation. When we run fiscal surpluses, we contract money supply, and hence create deflation. Hence, all budget deficits are "fiscal stimuli." When you look at things in this way, we've actually implemented a $6.7 trillion continuous stimulus package since 2008.

If you add up the deficits as a % of GDP that indicates a combined figure that has been equal to about 45% of GDP over the past six years. This is actually larger than the World War I deficits, which were around 29% of GDP. It's still below the World War II deficits, which were close to 95% of GDP, but this is the second largest series of deficits we've run over the past 112 years.

The question is, whether these large fiscal deficits are to become a permanent feature of the American economy over the next four years, and I think there's a reasonable chance they will. Of the two major political parties, neither has been particularly aggressive in trying to lower spending.

The Republican Plan (Paul Ryan's "Path to Prosperity") is the more fiscally conservative of the two, but still fails to balance the budget, and maintains an aggressive military spending posture. The Peter G. Peterson Foundation estimates that the Ryan Plan will eventually whittle the budget deficit down to around 1.2% of GDP. Even assuming the Republicans win both houses of Congress and the Presidency this fall, it's likely that those figures will prove to be very conservative once Congress begins to modify things. A best case scenario, in my view, may be that we run budget deficits of about 2% with a total Republican government.

Comparatively, President Obama's budget is projected to create budget deficits around 3% of GDP by 2015. Yet, the President is advocating major tax increases in order to reach that, which could cause a recession or at least, somewhat of a contraction in expected GDP growth. Couple this with the huge risks created by his healthcare overhaul and the Dodd-Frank financial reform bill, and I would not be surprised if we continue to see budget deficits larger than 4% to 5% of GDP if Obama wins re-election.

There is one wild card here: the fiscal cliff. My guess is that both parties will huff and puff, but in the end, the Republicans aren't willing to enact the giant tax hikes and military spending cuts; while the Democrats aren't willing to cut spending in general; so there will be some compromise that leaves us with a significant budget deficit.

Overall, we're not seeing either major political party be all that aggressive about balancing the budget, so the fiscal stimulus will likely continue, and eventually help create more inflation. While the media and Paul Krugman like to throw around words like "austerity," in actuality, even if we "go off the fiscal cliff," we'll still be creating a large fiscal stimulus; albeit, a somewhat smaller one. That brings me to the next problem.

Quantitative Easing, Part 3

I began my research on this issue a few weeks before the announcement of QE3 by the Federal Reserve. Given that my data suggests that inflationary risks are rising, I suspected that the Fed might decide to take a "wait and see" approach. I was wrong.

The Fed's first round of quantitative easing was absolutely necessary in my view, and was largely successful in staving off a severe monetary contraction. While far from perfect, this is exactly the type of policy that Milton Friedman might have advocated, and it was exactly the type of action that the Fed failed to take during the Great Depression.

QE2, on the other hand, was a pointless and ineffectual excursion by the Fed. Remember, the first QE package came right as we were entering a severe contraction. The second QE package came after the markets had already stabilized and we already had a zero rate policy in affect. At that point, I don't think there was much of anything that the Fed could do to help. At best, the policy was ineffective. At worst, it might have actually created some undesirable inflation.

If QE2 was ineffectual, QE3 might be outright dangerous. The open-ended nature of it is particularly troubling. But what really bothers me is that the Fed seems to be very explicitly targeting unemployment, rather than inflation. This is based on a horribly misguided economic theory, that inflation can create job growth.

Certainly, preventing a severe monetary contraction can help indirectly save jobs by maintaining liquidity in the markets, but the lack of hiring in the recovery likely has more to do with other issues. Dodd-Frank, Obamacare, and large tax increases scheduled to take effect probably have more to do with the high unemployment rate than monetary policy.

My concern here is that with M2 already spiking, QE3 can exacerbate things further, without actually helping much on the employment front.

How to Invest With Rising Inflationary Risks

I am a "margin of safety" or value investor at my core, but I also think the macro environment is very important. Luckily, there are a lot of sectors of the market that are priced inexpensively that will benefit from inflation.

Real estate is the best inflation hedge. While we've already seen a huge rally in the REITs (RWR) in 2009 and 2010, followed by a rally in the homebuilding stocks (XHB) in 2011 and 2012, I still believe there are a lot of attractive real estate plays. My favorite is Howard Hughes Corporation (HHC), which is sort of like a cross between a REIT and a homebuilder. HHC focuses on mixed-use, high-value properties, and I believe these types of properties are not only becoming more desirable to consumers, but are also the most likely to benefit in an inflationary environment.

The next sector I'd look at is insurers (KIE). The insurers have never recovered that much from the financial crisis, as they've been hit hard by low interest rates. But inflation will push interest rates upwards and could benefit some insurers immensely. While Genworth (GNW) is a riskier play in this sector, it's one of my favorites because it should benefit from increased mortgage activity and higher inflation.

Finally, the banks (KBE) are still very attractive. As I alluded to in my recent article on PNC Financial (PNC), nonperforming loans are on the decline, and mortgage activity is starting to improve. The banks should benefit significantly from this, as well as wider interest spreads that may develop over the next few years. Banks with high capital ratios are in particularly good shape right now.

Many of my favorite banks are smaller, little-known names, with strong capital cushions right now. This includes Popular Inc. (BPOP) and Pacific Continental (PCBK). However, these types of banks are also higher risk than their larger counterparts. If you're looking to take advantage of this thesis, but you want to play it safer, PNC is a great choice. Also, BB&T (BBT), M&T Bank (MTB), and Wells Fargo (WFC) are worth looking at.

My favorite pick in the banking sector is actually Citi (C), which I view as being extremely undervalued right now. While it has more risk than a PNC or WFC, I don't see it going away anytime soon.

I also find myself more interested in energy and utilities (XLU) now. Companies like Southern Company (SO), Exelon (EXC), and Duke Energy (DUK) have attractive dividends, and should be at least somewhat insulated from inflation.

One final note, and maybe it goes without saying. I'd favor stocks (SPY) over bonds, in general. The companies that will benefit the most from higher inflation are those with the highest debt loads, which means "risk-on" in the markets.

What Not to Invest In

I'd keep away from mortgage REITs (MORT) at this point. I bought into a few mortgage REITs in 2010 and early 2011, but the risk of rising interest rates keeps me away from these companies now.

US Treasuries (TLT) (SHY) (IEF) and high-grade corporate bonds are also unappealing. These types of bonds are the most sensitive to interest rate risk. Annuities are another thing to keep away from with rising inflation.

While many investors would recommend commodities with rising inflation, I'd be very cautious on that front. Many commodities, such as copper and iron ore, are highly correlated with China's economy right now. As China's asset bubble deflates, and as the Chinese government tries to shift the nation towards a more consumption oriented economy, it's likely that some commodities will get hit hard, even if we see inflation and more construction activity in the US. Economist Michael Pettis makes an effective case to keep away from copper. I've also shown in the past how vulnerable copper producers are to margin contraction.

Conclusion

While inflation may still be subdued in 2012, the risks certainly appear to be rising if M2 money supply figures are a good guide. Neither major political party has submitted a plan to balance the budget, meaning we'll likely see continued inflationary pressures via a constant fiscal stimulus. This could be compounded by loose monetary policy coming from the Federal Reserve. While, a lot can still happen with the upcoming elections, the fiscal cliff, and other events, I certainly think it's prudent to begin to shift one's portfolio towards protecting against rising inflationary risks.

Source: Inflation Risks Are Rising: How To Invest In A Tricky Environment