Sunday, April 6, 2014

Inflation Is Coming

by Sprout Money


People following the markets are a bit uncomfortable at the moment. Especially the abrupt drop in the technology sector is turning stomachs left and right. Volatility has returned it seems, and there is no denying that the way down travels faster than the way up.

Another trend we spotted was that a lot of capital is flowing out of technology into big caps, and at Sprout Money we always try to look at the big picture.

  • Why is this happening in the market?
  • Did something fundamentally change?
  • Is something going on in the background?

We do assume that we are in a transitional phase at the moment and as you probably know already, every market transition is accompanied by strong waves. What is going on then? Well, there is evidence that inflation is coming back, and we already had a taste of it with the jump in the gold price over the course of the first quarter of 2014. Most market watchers believe that gold was on the rise because of geo-political tension, but that is never the most important driver for gold.

Ultimately, inflation powers gold and nothing else!

With a little bit of investigation and research, it would be hard to not conclude that the inflation rate is going to be on the rise over the coming months. It does not require a science degree to figure out how the subparts of the official measure of inflation (the Consumer Price Index) are behaving as well.

The composition of the CPI (consumer price index) is as follows:

CPI components pie-chart

Source: Doug Short

In this diagram you can see clearly that the most important components are Housing, Transportation and Food & Beverages; together responsible for about 73 percent of the inflation rate! Of those three parts, only Transportation has not increased year-on-year. Food & Beverages, however, has gone up by a lot…

CPI food beverages chart

That should not come as a surprise to anyone. The prices of grain, coffee, meat, etc. have gone through the roof over the first quarter of 2014.

And then there is Housing. Although that component encompasses different things, the most important are real estate prices and rent. You have probably heard that the US real estate market is making a comeback, but rents are on the rise as well.

CPI rent chart

Do you see any sign of weakness in the above chart? We most certainly do not.

Even components in which you could notice a constant price decrease over the last few months, like information technology, are reversing.

CPI technology chart

You can see already where this is going: those who want to know where inflation is headed in the coming months simply need to look at its most important components. And most of these components are indicating an increase in the inflation rate. Gold has a head start already, as it is the ultimate monetary watchdog that can smell an increase in the inflation rate from miles away!

Now, if you listened carefully to the Fed over the last couple of months, you would have noticed inflation taking up a more prominent position in monetary policy as well. At the moment the inflation target is 2 percent, but Janet Yellen already indicated on multiple occasions that she would tolerate a higher inflation rate for an extended period of time to get the US growth engine roaring again. If we know one thing it is the following: NEVER fight the Fed!

If the Fed wants inflation, the Fed will get inflation. Mark our words.

Regular readers will remember that we indicated last year that tapering would be the Fed’s crutch for raising inflation. It was (and is) a controversial thought that was not received well by everyone, but it is the scenario that is playing out in front of our very eyes today.

The Fed is slowly turning off the printing press, and what do we see? Price increases over the whole spectrum.

The balance sheets of banks have been growing with freshly printed money from the Fed for years now, and 4 billion dollars have been injected already. That money will only start to work if the Fed stops bottle-feeding the banks. And then, all of that money will get shoved into the financial system by a factor of 10X (and more)! Do not forget that we still live in times of fractional banking.

We are very clear about this: a monetary avalanche awaits. Never before has a monetary operation of this scale been done as on other continents there are also billions of euros, yens, pounds, etc. ready to go to work. Fear (with baited breath) the moment this monetary snowball is unleashed.

Yellen wants inflation? Yellen will get inflation, and a lot of it, no doubts here. That is why we cannot emphasize the importance of gold as a component in your portfolio enough. Gold is the ultimate hedge against inflationary forces that are embedded in the system. Why? Simple. Gold flourishes in an environment of negative real interest rates, because only then financial products with fixed income (like bonds) do not generate any profits or protect capital. In a situation like that, money takes the path of least resistance: gold!

To get to negative real interest rates, you need the inflation rate to be higher than the nominal interest rate, and the current low interest rate policy from the Fed will remain unchanged for a good while. Only when inflation becomes a persistent problem, the Fed will fight back with interest rate policies but that will not be a topic for a long time… The CPI has to go north of 5 percent to get the Fed to hit the emergency brakes and today, the CPI is at a mere 1 percent.

USA inflation rate chart

We are also completely convinced that the Fed has no issues with a higher gold price whatsoever. Even more, the Fed would love a higher gold price as it would be a confirmation of the effectiveness of their monetary policy!

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