10 Sins Of Inflation

While my comments last month (see 7 Reasons Investors Should Embrace Inflation) focused on the positives of inflation, at least from the governments perspective, its long term and overall effects are always negative. The only reason it gains any traction in government is because it has various positives in the short term for bureaucrats and politicians, which I detailed last month. Aside from the fact that last month’s inflation positives are negatives for other than government and debtors, let’s review some more negatives:

1. It discourages investment and erodes savings thereby making planning and budgeting by individuals and industry hesitant and uncertain.
2. It causes an allocation of more capital into non-productive assets such as gold, collectibles, land, etc.
3. It causes hoarding and speculation which leads to price distortions, i.e. it is self- perpetuating.
4. It erodes peoples’ pensions and retirement savings so they cannot afford to retire. Those already retired face a reduced quality of life or becoming Wal-Mart greeters.
5. It leads to tax bracket creep for individuals increasing their tax rates in addition to the total tax amount.
6. It increases labor strife and disruptions as wage negotiations make unions more importance to workers.
7. It causes an inefficient allocation of resources resulting from the constant need to raise prices, which is also costly, e.g. restaurant menus.
8. It leads to speculative borrowing which increases investors’ risk as well as overall systemic risk for the financial system.
9. It invariably leads to an economic contraction when government decides the negatives outweigh the positives. They do this through raising interest rates and shrinking the money supply.
10. As inflation drives up interest rates, the cost to the federal government of financing a $14 trillion debt at say 6% becomes $840 billion a year – the amount of the entire budget not so long ago. This alone would be a $350 billion increase in federal spending over the cost today, which shows just how marginal is the current debate over getting $100 billion in annual budget cuts.

The consequences of inflation for the federal government are a host of new problems, usually involving the spending of more money to counter the economic contraction they caused in the first place. But then, this is the history of government actions, a high percentage of which are directed at remedying past policy mistakes.

Individual investors need be pro-active if they wish to avoid the consequences of inflation.

My recommendations for asset allocations are:

• 25% in adjustable interest rate debt securities
• 30% in stock market sensitive issues, i.e. convertible stocks and high dividend paying blue chip stocks
• 20% in energy securities and master limited partnerships
• 15% in high dividend paying special purpose closed end funds, i.e. commodities, energy, adjustable rate debt and stocks
• 10% in gold, silver and platinum ETFs

We follow this strategy for our managed accounts and attempt to achieve this diversity in the Multi-driver Portfolio.

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We left this story last month with the happy expectation that Fed Chairman Bernanke was going to be deflating the carry trade bond bubble, bring long term interest rates in line with inflation expectations, stimulate bank lending and thereby create economic growth.

As this plays out monetary velocity, i.e. the frequency money turns over, will increase giving us the moderate inflation Ben is hoping to induce. The problem with this hopeful scenario is that the rate of inflation will likely be much higher than desired.

The Fed’s plan would be that once the desired inflation level is reached, they will begin selling off the $600 billion in treasuries they acquired under QE2. Such sales will decrease the money supply, the first shoe to the inflation equation. This will also have the effect of driving long term interest rates even higher in the search for buyers. It will also have little effect on the velocity of money, which should actually increase even more as the increase in interest rates fuels even more inflation angst.

The Fed has little or no influence on the velocity of money short of raising short-term interest rates to a level that causes an economic slowdown or recession. Even then, if they don’t play it right, they can get their economic slowdown and still have inflation (better known by the term ‘stagflation’.)

Even those who try to protect themselves against inflation by buying TIPS and other adjustable rate securities find their refuge is limited by the fact that government decides how much inflation to report. By excluding such essentials as food and fuel from the CPI (called core CPI) they miss much of the real cost of living. This is especially so since housing is 42% of the overall CPI index, but becomes 51% of the core index when food and energy is stripped out. Given this distorted percentage for housing which continues to decline, don’t expect core CPI to give a realistic reading anytime soon. It has been reported that if inflation today was measured as it was in the 1980’s we would be reporting a rate of 9% rather than 1.4%. Hint, you may want to avoid treasury TIPS, which are tied to core CPI.

To make matters worse, through what is termed hedonic adjustments, the government makes subjective judgments about product equivalents (i.e. a computer today may cost more but, is 4 times better than one sold five years ago; ergo in their calculation, the price actually declines! The fact that you don’t use or need the snazzy new features is irrelevant.) It is such data manipulation which allows politicians to have inflation while by-passing mandated budget cost increases tied to the CPI.