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On August 12, 2009, the US Federal Reserve indicated that it intended to stay the course, postponing effective action that might ward off high inflation once the Obama “spending is stimulus” money hits the fan.

Money as wallpaper. Germany 1923.

Bernanke fears deflation, not inflation

Non-independent Fed Chairman Ben Bernanke, running for reappointment, is not eager to adopt strong, anti-inflationary measures that might be unpopular.

The Obama administration desperately needs rising employment statistics to boost the President’s sagging popularity, while postponing the advent of inflation until after the 2010 elections.

Spending is stimulus — for inflation

Former Chairman Paul Volcker, renowned for his tough taming of inflation during the Reagan administration, has been neutered to a powerless position on Obama’s economic advisory board, giving the President political cover of the Volcker reputation, without substance.

Both Larry Summers and Tim Geithner have gone on national TV to announce that Obama’s “spending is stimulus” actions would result in higher taxes. What this means is that Americans can expect to see both high levels of inflation with depressed employment (the result of higher taxes).

So, what this seems to indicate is that sometime in the future the US economy will hit a transition point when inflation will begin to kick in with a vengeance. Interest rates will soar. The value of long-term bonds will plunge.

Equities will be squeezed by stagnant sales due to the continued recession and high borrowing rates.

Transiting  to an inflationary economy

The Federal Reserve’s record of timely action to prevent inflation is not encouraging, and barring something really dramatic (like Paul Volcker resigning from the President’s panel in protest), it seems that a transition to stagflation is in the cards.

The spread between short-term and long-term interest rates is now high and increasing. As the tipping point into inflation gets closer and closer, this differential should increase even more. In the process, holders of medium and long-term bonds will experience a loss of wealth.

At some point, long-term debt is likely to sharply fall in value. When inflation kicks in, the price of long-term bonds will stay down for a long time.

Leveraged holders of medium and long-term debt will suffer severe losses.

When debt is good

Those who managed to take out long term mortgages on their homes at today’s bargain rates will suddenly appear to be financial wizards.

Companies that wait too long to ameliorate their over-extended positions will finding bond financing far to expensive and will have to consider raising cash by selling equity (forcing down stock prices) or by rolling-over short-term debt (forcing up short-term interest rates).

This means that rates on money market funds and short-term CD should rise as inflation hits, while prices of medium and long-term debt fall.

See: Money market funds will tell us when inflation is here.

A strategy for survival

If this scenario plays out in real life, the survival strategy today (August 2009) would be to get out of long-term securities (stocks and bonds) and hold quality money market funds.

This means losing current income from current rates on longer term bonds and potential profits from a possible continuation of the rally in stocks.

However, history offers many examples of sudden changes in market perceptions. The question is whether the transition to inflation will be gradual, say over two or three years, or sudden — in two or three months.

For well over a year, there were many warnings of a potential crash in equity prices, but the actual event happened suddenly in September-October 2008, leaving investors with little time to exit.

See: Buyback Bubble Pops! The Long Ways Down …

Cash might be king

Now, it may seem counterintuitive to go into cash in the expectation of inflation, since everyone knows that holding cash offers no protection against inflation.

However, the logic here is somewhat different.

1. When inflation hits, it may be sudden, not affording investors a chance to get out of bonds and equities.
2. The interest rates on money market funds can be expected to rise quickly when inflation hits, perhaps exceeding the rate of inflation.
3. Once money market fund rates confirm that inflation is indeed here with a vengeance, the investor can then reassess the situation, going back into bonds or equities as may seem advisable.

If an investor holds $10,000 in a bond yielding 10% today, and the interest rate suddenly jumps to, say, 18% when inflation hits, he or she will continue to earn income of $1,000 on that bond. However, by selling the bond today and going into cash, and then reinvesting after inflation hits at 18% in the same bond, the investor’s income would now be $1,800 — 80% more than simply holding the same bond.

There are reasons to suspect that the current rally in equities may not be sustained.

See: Formidable barriers to a bear market recovery

The coming storm

The storm flags are flying — warning of inflation.

Storm coming

No one knows what will happen, however since the Crash of 2008 was a precipitous event, as was the enactment of the trillion dollar stimulus packages, it seems at least reasonable that the coming of inflation will also be quick and sudden.

So the question is, if you knew that inflation was suddenly to jump to 8% next month, how would you be best invested?