Scary picture being painted.....

Thus far throughout this crisis I have been a deflationist. However, doing some research this weekend, I am starting to come to the conclusion that we may see rapid inflation before I recently predicted. The reasons I am starting to see are coming about because of our monetary system. In a monetary system where the currency is backed by gold or other tangible assets you can have long periods of price inflation and deflation. However, in a system where the currency is back by essentially nothing you generally tend to only have one thing, inflation. This system is refered to as a 'fiat' currency system and it is the one that we have used since 1933. My previous predictions of deflation have come from comparing recent happenings with the Great Depression. However, when the Great Depression started in 1929 we had a currency that was backed by gold. Therefore, the Federal Reserve could not pump unlimited amounts of money into the system to prop it back up. This led to a deflationary spiral until 1933 when Franklin Roosevelt took us off the gold standard and gave the Fed unlimited ability to print money. Graph #1 shows when this change took place and how inflation essentially turned on a dime in 1933.

Graph #1

So, what does this mean for the prospect of impending inflation? It means that when the Fed increases the monetary base we should pull out of this deflationary period we are experiencing right now and have a rapid inflation. This doesn't mean that the economy will turn around. If anything, I believe it will just make the economy worse because the dollar will be severly devalued and U.S. citizens will lose half of their purchasing power. This next chart shows the effects of inflation on the value of the U.S. dollar since FDR pulled us off the gold standard in 1933.

Chart #2

Looking at that chart is very startling to me and it is only going to get worse in the near future. I believe the dollar can fall another 50% before the entire financial crisis/depression is all over. One only has to look at a chart of the U.S. monetary base to realize the grand scope of this fiasco. Here is a recent chart of the increase in the U.S. monetary base.

Chart #3

The increase in the monetary base is just staggering. Nothing has ever been seen like this before in the history of the world, let alone just the United States. We are truly venturing into uncharted waters.

What does this mean? This means that commodity prices should start rising again. It means that the dollar will start losing its value again. It means that people holding large portfolios of bonds will be hurt because inflation will be higher than the returns they are getting from their fixed income securities. What inflation basically does is redistribute wealth from the retired and soon to be retired to the young working class. Inflation destroys wealth, and the people who have worked the hardest to accumulate and protect their wealth over the years are always the hardest hit.

How do you protect yourself? You must hold assets in your portfolio that appreciate with inflation. This means holding hard assets like oil, gold, silver, and other commodities. Once the stock market starts to recover it means buying stocks such as oil producers, gold miners, agricultural companies, oil royalty trust, and certain real estate investment trust. Also TIPS bonds can be purchased. These are Treasury Inflation Protected Securities (TIPS) and are guarenteed to hold their value during high inflation peroids.

Right now I am watching a lot of differnet indicators and they are started to predict inflation. I'm believe that within the near future oil will start outperforming gold again. I think gold and silver are due for a pullback, but soon they will be giving me a buy signal again. I'll keep you posted.