Smart Money Bets on Inflation

11/08/2010 10:02 am EST

Focus: MARKETS

Terry Savage

Author, The Savage Truth on Money

What are the markets telling us when US stocks make new two-year highs, and gold soars $55 an ounce to $1,393 in a single day—right after the Federal Reserve announced its new program of “quantitative easing”?

They’re saying the “smart money” is betting that inflation is on the way—despite the Fed’s worry about a slowing economy, and despite weak jobs numbers, and the continued housing slump.

Many people mistakenly think that inflation is an economic force, when it really is a monetary problem—too much money being created. And the Fed’s announcement that it plans to create another $600 billion, out of thin air, has unleashed inflation fears.

The Fed says it’s buying Treasury bonds. What might not be so apparent to the average citizen is that the Fed is paying for the bonds it buys with newly created credit—literally writing a “check” that gets deposited in the account of the bond sellers. That’s how the Fed “prints” money these days.

Where will all that money go? Banks and corporations already have plenty of money sitting in their coffers—and they’re unwilling to make loans to risky customers. So, it’s a good bet that a lot of that new money will flood into the stock market, both here and abroad, despite the bad business climate. That’s why stocks have reached new two-year highs and why foreign governments are trying to stem the flow of all those dollars into their economies and markets.

And that’s why gold is soaring. No one can create gold out of “thin air.” They’ve been trying that since medieval alchemists, King Midas, and Rumplestiltskin!  Gold retains its value throughout the centuries, because governments can print paper money to try to stimulate prosperity, but they can’t create gold.

Here’s another irony: The Fed says it’s buying government debt to help keep interest rates down.  But if inflation fears really spread through the global economy, the smart money will demand higher rates to compensate for the loss of value in the dollar because of inflation. 

All rates will rise—on adjustable rate mortgages, credit cards, and consumer loans—causing more damage to the economy. Savers will cheer those higher rates, not realizing that they are only offsetting the falling spending power of their dollars.

Inflation means the dollars you’ve saved won’t buy as much in the future. When investors fear inflation, they either demand higher interest rates as compensation or they switch to “hard assets”—from gold to silver to commodities to other currencies. 

Until now, the Fed has been worried about deflation—falling prices. But if inflation fears take hold, they’ll find themselves fighting a much stronger monster.

What do you think? Is inflation about to make a comeback? And how are you trying to protect yourself? Please have your say and join the conversation.

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