-- Posted Tuesday, 31 January 2006 | Digg This Article
Zach Fross
When talking about defense against inflation, there is reason to have a solid strategy of protection against the enemy. But what exactly is the enemy? How does the enemy operate? Why is the enemy inflation? How can wealth be defended against it?
When inflation is reported in mainstream media, lots of numbers are spewed forth and acronyms like CPI are often made reference to. What is the CPI and is there truly an accurate measure of inflation? Lets start with a working definition of inflation.
True inflation (referred to as monetary inflation) is an increase in the money supply. This includes: the increased printing of fiat currency, any bank loaning money it does not currently have possession of (either to another bank, a country, or an individual), and simply by paying interest on these loans with money that has been printed for this purpose. U.S. Federal Reserve measures monetary inflation by what’s called monetary aggregates, or M1, M2, and M3 – M3 being the most inclusive measure of the actual money supply.
The U.S. Federal Reserve uses the CPI as the measure of inflation as given to the public. According to the U.S. Department of Labor’s Bureau of Labor Statistics, “the Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.” The value placed on the basket of consumer goods is determined by “using hedonic quality adjustment methods.” Or rather the basket is composed of categories of goods and the lowest priced good in a particular category is used in the calculating of the CPI.
For example, if meat is the category and chicken and beef are the goods in the meat category and chicken is the least expensive, then only the price of chicken will be a part of the current month’s CPI. If the following month, beef is the cheapest, only the price of beef will be used. Thus the CPI could change 3% over a period of time, and the price of chicken could increase 9% over the same period. According to the CPI chicken increased 3% but according to your pocketbook, the price of chicken rose 9%. Because true inflation is the increase in money supply, an increase in the price of chicken and not beef is due to supply and demand, not inflation.
The most common method the Federal Reserve utilizes to increase the money supply is by lowering the federal funds rate. This is the interest rate at which the Federal Reserve loans money to private banks. When the interest rate is low, there is more incentive for banks to borrow from the Federal Reserve then loan the newly acquired funds to businesses and individuals.
The Federal Reserve is able to create the money available for loan out of thin air by adding money to its credits column. This is what might be called Creative Accounting and only the banking system can get away with this practice. This practice is also used when the U.S. government borrows money from a foreign bank. The interest payment is simply created on the books and then the payment is made. Any private individual who tried to use this type of method for creating money would be tried for fraud under the RICO act.
Monetary inflation becomes highly attractive to a government when taxes are already high and more money needs to be raised for further expansion. When the Federal Reserve increases the money supply the private individual is the one who gets stuck flipping the bill.
For example, if there is $10,000 already in the money supply, the total goods for sale can be purchased for $10,000. This is worked out naturally through the free market. If all of a sudden another $10,000 is flooded into the money supply, all goods being sold can be bought for $20,000. The purchasing power of the original money in the money supply has been effectively cut in half and those people less fortunate to have hung onto their hard earned money just lost half of their savings. The affects of an increase in money supply are not realized until six months to one year after the increase has taken place. This is usually then blamed on the weather or some such ridiculous event that has nothing to do with the all-around price increase.
The increase in the money supply has had numerous side affects. No longer can a family be supported on one person’s income just to survive let alone have enough money left to send the kids to college. Social Security has become entirely depleted and the money being paid to retirees from Social Security isn’t worth enough to enable survival. The age of retirement is getting older and the number of people who continue to work after retirement is on the rise. The U.S. (including private individuals) in 2006 is more in debt than any country in the history of Man. More and more people are filing for bankruptcy and savings are at an all-time low. Look around and ask if this is because “inflation” is supposedly a cool 3% a year or is it because the true inflation percentage is much greater.
It just so happens that there are ways to protect oneself from the nasty affects of monetary inflation policy. Currently the precious metals’ market is growing at a rate that is out pacing inflation. This is due to several reasons, one of which is that people are beginning to see the decline in not only the U.S. dollar, but also any fiat currency that has a devaluation policy behind it. Countries all around the globe are trading their reserve currency for gold and silver to protect their wealth against the inflation of most countries’ fiat currency.
There are several ways to get invested in precious metals but a solid investment strategy must first be developed. Part of developing a sound strategy is determining weakness and clarifying some basic goals. Lets examine fighting inflation with gold. Not only can we investors protect our wealth against the dollar and other fiat currencies by buying gold bullion, but can also take an offensive position by buying shares of a gold mining company. This leverages the investor’s investment and as the effects of monetary inflation become more severe, the portfolio becomes increasingly more aggressive. The key to this is no longer keeping a widely diversified portfolio (i.e. buying into the S&P 500) but by assessing needs and exploiting weakness.
If I am in my 30’s and have a limited amount of capital, and recognize the weakness of inflation, I may choose to protect some of my wealth by investing in gold bullion and transferring the remainder of my assets to small and medium sized gold mining companies. I can minimize the risk of such leveraging by intensively researching the history and the management of the companies to determine the likelihood of large returns on invested capital.
Patience is a key to a strong strategy. Remember, the strategy was developed during a period of relative calm; a period during which sound judgment ruled over strong emotions. Be sure your strategy includes plans for times of high stress and emotion. This plan could be as simple as knowing the type of market you are in. If you are in the gold market, and you know that gold is a bull, then you can be sure to buy instead of sell when the value takes a slight dip. This not only protects against emotions but also increases profits when gold continues up. Have patience and confidence in your strategy to stick with it and not give in to uncertainty and emotion. Remember, if you have made large profits, it is okay to sell and buy into the next big market - buy low, sell high.
If you know the enemy and know yourself, you need not fear the result of a hundred battles. If you know yourself but not the enemy, for every victory gained you will also suffer a defeat. If you know neither the enemy nor yourself, you will succumb in every battle.
Sun Tzu – Art of War
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© January 2006
-- Posted Tuesday, 31 January 2006 | Digg This Article
