Dr. Mohamed A. El-Erian, the PIMCO CEO, is of the opinion that the Federal Reserve and Chairman Ben Bernanke not only are willing to tolerate inflation, but are actually trying to create higher inflation. Mr. El-Erian calls the policy a "Reverse Volcker Moment."
This article looks into the reasons for believing that inflation will be meaningfully higher in the medium to long-term. In line with this expectation, the best investment options are discussed.
The bear market for Treasury bonds ended in the early 1980's after Mr. Volcker's strategy of controlling inflation through high interest rates yielded results.
Since then, interest rates have been trending down and will remain at near-zero levels for an extended period. Even if interest rates trend higher, they will remain negative (adjusted for inflation). The reverse Volcker moment, combined with QE3, has the potential to create runaway inflation like the 1980's over the next decade.
The first trigger for higher inflation is keeping interest rates at near-zero levels until mid-2015. Negative returns on deposits (adjusted for inflation) would encourage investors to speculate in asset classes such as industrial commodities, energy and even in agricultural commodities. As prices trend higher for commodities, inflation will increase globally.
The disconnect between commodity prices and the real economy was evident recently with Brent crude surging over $116 while the global economy is in a manufacturing recession.
QE3 also has the potential to bring about a massive injection of liquidity in the economy. Over the long-term, QE can be a highly inflationary exercise.
If the Fed were to purchase $40 billion of mortgage-backed securities until mid-2015, the total liquidity injection into the banking system would be $1.3 trillion. Further, the Operation Twist policy (if extended until mid-2015), would result in an additional liquidity injection of $1.5 trillion.
Further, banks already have USD1.5 trillion of excess reserves with the Fed, which can potentially flow into the real economy at some point of time leading to a significant surge in inflation.
One might argue that the Fed can raise rates on excess reserves to prevent inflation. However, if the banks see a greater incentive in deploying the money elsewhere, raising rates on excess reserves would not help in controlling inflation.
Policymakers need to understand that flooding the system with liquidity would not work when it comes to helping the real economy. Liquidity will only aid different asset classes globally to trend higher. This might create wealth or wealth illusion, but just for a few.
The futility of the money printing exercise is evident from the slide in money velocity, which is at its lowest since the 1960's. Further, the M1 money multiplier has also remained below one ever since the crisis started.
These indicators point to the fact that the real economy is significantly weak and liquidity is not the answer to the problem. The core issue, which is a manufacturing renaissance and increasing overall industry competitiveness, needs to be addressed.
Continued higher deficits would be another source of triggering the reverse Volcker moment of higher inflation along with suppressed interest rates. According to the CBO, if the tax increases and spending cuts don't come into effect in 2013, deficits would total nearly $10 trillion over the next 10-years.
I am of the opinion that this is a very likely scenario amidst sluggish economic growth and rising government expenditure related to the Medicare, Medicaid, Social security and food security programs. Deficits are one of the biggest sources of additional liquidity in the financial system. Therefore, it would not be surprising to see higher inflation along with higher deficits.
Readers might argue that there are no indications of high inflation even after four years of witnessing expansionary monetary policies. It has to be remembered that inflation is evident with a lagging effect and we might already be witnessing early signs of higher inflation (especially in energy and agricultural commodities).
If investors do find these arguments convincing related to inflation in the medium to long term, this would be a good time to adjust the portfolio for beating inflation.
A very obvious choice would be to invest in gold. Physical gold is a preferable choice for investment to gold ETFs. I don't want to sound very scary, but Dr. Marc Faber's opinion on storing physical gold outside the U.S. is a good idea, as the possibility of expropriation of gold can't be ruled out. For investing through gold ETFs, the SPDR Gold Shares (NYSEARCA:GLD) ETF is a good option.
I also remain bullish on silver, which has the potential to outperform gold in the long-term. With the industrial application of silver being greater than that of gold, the price driver would be more than just money printing globally. The iShares Silver Trust (NYSEARCA:SLV) ETF would be a good way to invest in silver other than investing through silver coins.
As mentioned earlier, I am also positive on energy and energy stocks. In the last three years, global energy stocks have given returns of 27%, which is good by any standards.
Going forward, I expect energy prices to trend higher and benefit companies related to oil drilling, exploration and services. To benefit from higher energy prices, investing in the Vanguard Energy ETF (NYSEARCA:VDE) would be a good idea. The ETF seeks to track the performance of a benchmark index that measures the investment return of stocks in the energy sector.
If Fed fund rates do remain negative (adjusted for inflation), I expect equity markets to do well. Besides investing in quality stocks with a high dividend yield, I would invest in the index. Index investing can be done through the SPDR S&P 500 (NYSEARCA:SPY) ETF, which generally corresponds to the price and yield performance of the S&P 500 Index.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.