The next big bet, inflation???

By: ispeculatornew
Date posted: 07.03.2009 (5:00 am) | Write a Comment  (3 Comments)

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moneysIt is a fairly known law in economics; pumping new money in an economy will lead to inflation later on. There is little to argue about and yet in a period of high crisis, that is exactly what the US government decided to do. Not to say that there were better alternatives. With crippled credit, pumping money (and lots of it) into the system was probably the only alternative. And so the real objective now will be for the US government to pull out its money in time before inflation spins out of control. Will it be easy? Of course not. That is the problem with most governments, they get into businesses but fail to get out in time.

The Wall Street Journal as well as Bloomberg have been reporting news of funds that are putting up huge bets on inflation going out of control, also called “hyperinflation”. Will it happen? Difficult to know. But having an increasing number of very smart people place bets on this certainly is a worrying trend. “Inflation uncertainty is probably wider today than at any time before the financial crisis,” says John Hollyer, co-manager of the $22 billion Vanguard Inflation-Protected Securities fund. “So having that protection in your portfolio is still valuable.”

What are good investments to hedge against inflation? There are many different ways to play it, but the two main ones are:

-Inflation protected bonds

Basically, commodities have generally been known as a good inflation hedge. Why? Because when prices go up, these assets keep their values while other assets can lose theirs. It is mostly because they have concrete value and if prices of everything goes up, owning “stuff” will mean that their value will go up as well

Inflation protected bonds are quite simple. They are bonds issued by the uS government but have one major difference. While the government might issue a bond paying 5% for example, these bonds would pay a differeny payout:

Inflation+3% for example

So yes, if inflation flies to 12%, then the government would be paying interest of 15%, not bad right? So far, the prices that inflation protected bonds (TIPS) are trading at imply a very low expected inflation. Why? Because most investors expect the US government to act on time. When we say government, we mostly mean the Fed. The Federal reserve’s main task in fact is inflation control.The Fed defends itself by saying that the economic law regarding inflation does not relate to the amount of money available but rather:

Money x Velocity

Velocity is the number of times that each dollar is used in one dollar. A few years ago, an individual would borrow to buy a house, then the bank would sell the mortgage to an investment bank, who would sell a repackaged product to investors, etc. But lately, money is not flowing as easily and because of that, the Fed maintains that inflation is still very much out of control. The real task if they are right is to carefully monitor the velocity so that when it picks up, the US starts to withdraw all the liquidity it added into the market… it should make for some interesting next few months and years.

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