Dr. Stephen Leeb's  Instablog

We've been arguing for some time that the Federal Reserve and others who influence the economy must choose between two great evils – inflation and deflation. No middle ground remains open.

What's more, inflation remains the more palatable of the two. A nation can endure high inflation for a time without destroying its long-term economic prospects. For example, after World War Two, Japan experienced inflation on the order of 40% annually for several years. Yet it segued from that ordeal to become an economic juggernaut for much of the seceding decades.

Similarly, high inflation plagued Brazil during the early 1990s. Yet today Brazil is one of the strongest emerging economies. The U.S. can only envy its growth rate. Warren Buffett, moreover, has singled out Brazil's currency as one he would like to invest in.

On the other hand, economic depressions have far more severe aftereffects and require more drastic measures to solve. It took over ten years for the U.S. economy to recover from the Great Depression that began in the early 1930s – and even then it was only the massive spending and industrialization necessary to fight WW2 that caused growth to reach 15% that pulled us out of our slump.

Similarly, many people don't realize that the hyperinflation which plagued Germany in the 1920s was a short-lived phenomenon. While the suffering it caused may have contributed to the rise of Hitler, it was really the hardship of the 1930s depression that gave the biggest boost to the Nazis' careers.

People can adjust to and even weather high inflation – even double-digit inflation, because high inflation does not necessarily destroy the social structure. As long as the social structure remains intact, measures can be taken to improve the economy, reduce future inflation, and set the stage for a healthier economy. Depression, however, can destroy the social structure, making it difficult to invest in solutions.

In our situation today, high inflation would clearly be the lesser of the two evils. It might chasten us to aggressively develop alternative energies. More plentiful energy would then free us from future inflation caused by dwindling oil supplies.

As you probably know, we expect high inflation will be the path our economy takes. However, depression remains a possibility. In fact, today we seem to be at a crossroads. For instance...

FRAGILE GREEN SHOOTS

The close correlation between commodity prices and the stock market today suggests that further gains in stock prices, further “green shoots,” will be accompanied by rising inflation. As long as the economy remains sluggish, inflation becomes a kind of tax, a suppressor of consumer spending and investment.

Therefore, if commodity and stock prices keep rising, the Fed must be willing to loosen credit or risk a deflationary event such as we had last year. You recall that the Fed failed to see higher oil prices as an economic suppressant in 2008. Keeping monetary policy too tight resulted in October's nasty stock market crash.

On the other hand, if the stock market rally soon reverses (and we think it will), that will be the end of the only green shoot. All the other economic stats are anything but green – home prices, unemployment, mortgage applications, interest rates up, etc.

In the event of a stock market correction, the Fed will have no choice but to add considerably to its balance sheet, even though the balance sheet is already a quantum leap above anything we've ever seen in history. Aggressive money creation and liquidity would be the only option. The Fed will feel that the stock market, as the only green shoot, must be nurtured.

On top of that, with 2010 being an election year, the government cannot allow a worse economic disaster to unfold. No incumbent politician wants to campaign during a period of misery.

So no matter what happens, we feel the Fed will maintain its loose monetary policy. If the stock market rises, so will commodity prices and inflation, and the Fed will need to loosen credit so the economy doesn't become choked. If the market falls, the Fed will need to loosen credit to stop the fall and stimulate growth.

With no choice but to keep easy money flowing, keep the balance sheet rising, the Fed's actions will make higher inflation inevitable. Record levels of money creation can only result in a less valuable dollar and higher prices. Looming resource shortages ready to emerge on any hint of an economic recovery will create inflation by other means. Our only questions regarding inflation are “when” and “how much.” We have no doubts about “if.”

Making money under such conditions may be challenging, but the methods are clear...

THE TWO BEST INVESTMENT AREAS

To beat inflation over the coming months, you need to own growing companies with footholds in not just Chindia but also the BRAC nations – Brazil, Russia, Australia, and Canada. These resource-rich nations will resist inflation better than any.

Fears about the world economy may push commodity prices lower for a short time, but any hint of a recovery will benefit resource-based investments.

Meanwhile, we want to emphasize gold over all other investments. Though gold has had a tough couple of weeks, and is off to a bad start today, it is only a matter of time before its value as an inflation hedge causes it to outperform substantially most other assets. Meanwhile, gold also offers protection against deflation and recession, which will send investors fleeing for the safety of hard assets.