I believe the most powerful force driving economies is total spending, known as aggregate demand. Inflation occurs when total spending in the economy rises above the capacity to produce and meet that demand. Deflation occurs when there is too much slack between spending and capacity. Total spending in the economy can be positively or negatively affected by a number of factors. The most significant and subject to change is the extension and contraction of credit known as credit cycles. Credit creates money and spending. The reason is when a loan is extended, money is made available to the borrowing individual that he or she did not previously have. This money is then spent, usually shortly after being borrowed.
I would like to stress the self-reinforcing nature of spending and positive feedback mechanisms in economies. When the economy is operating at a high level of capacity unemployment is low, corporate profits are strong and asset prices such as stocks and homes are rising. This has multiple effects.
1) Increased collateral values affect the creditworthiness of borrowers creating more capable borrowers and willing lenders.
2) Stock and home values are large drivers of net worth. Rising net-worths make individuals feel wealthier and more willing to spend or borrow. This is largely a psychological effect.
3) Incomes and wages increase due to a fully employed work force and strong demand for employees.
The effect of the above events is increased spending leading to high capacity utilization, a low unemployment rate, strong corporate profits and rising asset prices. These all lead to increased spending. Economies can spiral downward, as well as upward. When capacity utilization is low, the unemployment rate is high, asset values are declining, and consumer confidence is low. This makes individuals more likely to save and less likely to borrow. This causes decreased spending, further weakening the economy.
Central banks have power over the economy due to their ability to affect interest rates. Interest rates are essentially the cost of credit or money. Money and credit are price elastic meaning demand is dependent on price. When credit is cheap, that is, when interest rates are low, the demand for loans increases. When interest rates are high, credit or money is viewed as expensive and demand for loans declines. If the economy is viewed as being too weak lowering interest rates creates demand for loans, which leads to higher spending. If the economy is overheating or when spending is uncomfortably pushing up against capacity, raising interest rates can cool off the demand for loans and lower spending.
The central assumption when conducting monetary policy is there are always an adequate number of willing and capable borrowers. This however, is not always the case. About once every hundred years debt levels become too high on an economy wide basis and there is not enough borrowing regardless of interest rates to meet policy objectives. The central bank will lower the Federal Funds Rate to 0%. This is known as the zero lower bound because interest rates cannot go any lower. If sufficient borrowing is not stimulated at this level, conventional monetary policy has reached it's maximum effectiveness.
At this point debt levels must be reduced and the key element in this process is time. Debt levels are best reduced through austerity. That is simply paying down debt and deferring spending. This is deflationary and creates a vicious downward cycle for the economy. To combat this, the central bank will create brand new money and purchase private sector financial assets. The goal is to inject this newly created money directly into the economy. This is known as quantitative easing. The effect of quantitative easing is it reduces the scarcity of money for debt repayment and helps alleviate debt burdens. This money printing is best regarded as reflationary, not inflationary, because the effect is offsetting deflationary forces.
This is the situation the United States currently finds itself in and previously found itself in during the Great Depression. Now and the 1930's have been the only two time periods in the history of the country where the Federal Funds Rate has been at 0%. Eventually, previously indebted borrowers will repair their balance sheets and begin taking advantage of the lowest interest rates in their lifetime. The economic strength caused by this will be the catalyst for inflation. This will force the Federal Reserve to turn restrictive by raising interest rates and a recession will most likely ensue, similar to the recession of 1937.
The next five years is guaranteed to be a very volatile time for investors and there will be treacherous waters to navigate. I am most bullish on precious metals and commodities. Commodities I find particularly attractive are high quality metallurgical coal, rare earths, silver and gold. Walter Energy (NYSE:WLT) is the only pure play met coal producer and Molycorp (MCP) is the largest rare earth miner and processor outside of China. I believe Pan American Silver (NASDAQ:PAAS) and AngloGold Ashanti (NYSE:AU) are the top gold and silver miners, respectively. Unlike the S&P, many mining companies are valued attractively and when inflation becomes evident these companies will experience a run-up similar to 2011. Of course, you don't want to stay at the party too long because when the Federal Reserve raises interest rates these miners will be hit hard. As the economy heats up, I would recommend holding an offsetting short position in the bond market to hedge the risk of unexpected Federal Reserve tightening.
I will close with a couple comments on the infamous taper. The announcement itself is of more importance than the actual reduction of money creation and asset purchases. The reason the announcement is important is because it can have an adverse effect on inflationary expectations. Inflationary expectations affect business' decisions to hire, expand and invest. Also, the market is sure to overreact to the announcement, which could cause a spike in long-term interest rates. For those reasons, I do not expect any tapering until inflation starts moving toward the 2% target. Overall, the taper is best looked at as the Federal Reserve easing the pressure on the gas pedal, which is distinctly different than taking their foot off the gas pedal or hitting the breaks.
Disclosure: I am long MCP. 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.