Tuesday, June 3, 2008

The Fed's inflation conundrum

Remember long term tenet #1? If given the choice between inflation and deflation the Fed will inflate.

The Fed is now between a rock and a hard place. The deflation in the real estate and credit bubbles requires inflation of the money supply or the masses are going to feel pain. Lot's of pain. This kind of pain isn't good during election years. The Fed has faithfully responded by following rule #1 to a tee. Keep in mind it's not really going to stop the deflation in either of those markets. It may prolong and probably intensify the pain but it's not going to stop the process from unwinding. Both bubbles will continue to deflate. As a matter of fact they are going to decline much more than is necessary. That's just how human nature works. They will likely drop to the same degree of undervaluation as they rose to overvaluation.

Real estate just went through the largest bubble in history. Much larger than the tech bubble. This doesn't bode well for the final bottom in the housing market. I seriously doubt this deflation will stop before housing loses at least 50% of it's value from the 05/06 highs. Does anyone seriously think the banks are going to bottom as long as this process continues?

So now we have the Fed desperately trying to stop deflation in the real estate and financial sectors but what they are actually doing is again creating a much much bigger problem. I think it's safe to say the the inflation genie is out of the bottle. Once he's out he's very tough to get back in.

Here's what is going to have to happen. First off enough time is going to have to pass for the supply and demand imbalances to be overcome in the commodity markets. Second the Fed is going to have to raise rates aggressively and create a severe recession or depression. How many think that the Fed will be willing to do that?

The easiest time to do it would be right now as it's just getting started. The problem is we are already in a recession. As I've said before the fun part of monetary inflation is now over. We are most likely going to be in a period of either very sluggish growth or recession for several years to come. How does the Fed do what they need to do in that kind of environment? I don't think they can and I don't think they will. The deficits in the US are so huge they will never be paid unless the currency is debased. Just another strike against the Fed tightening.

All this talk about the Fed tightening rates soon is ridiculous. It ain't going to happen. No the Fed is going to continue to inflate and we are going to continue to suffer the consequences of that inflation.

The only way to protect ones wealth during this period is to invest in commodities or be one heck of a market timer. Since probably less than 10% (I'm being generous) of investors are going to be able to time the markets successfully your best bet is to buy commodities.

All this talk of gold collapsing is just ignorant IMO. Keep your eye on the ball and you will come out of this period in fine shape.

I'm waiting for one of two things to happen before loading up on PM again. Either we move into the latter part of the summer or the market declines and I see the Fed panic again and turn up the money supply even more, which ever comes first.