How to Pay Off Debt… Stealthily

There’s Another Way

There are three ways for a government to pay for debt: issue new debt, collect taxes, and cause inflation.  Inflation is a ‘hidden tax’ on a populace- it decreases the value of future money, and allows governments to pay off their current debt with devalued money.  The United States dollar, as the world’s reserve currency, gives the United States a unique temptation (opportunity?) to pay off their debts in a currency it can print.  What exactly is inflation, though?  And if you believe inflation is on the way, how do you set yourself up to counteract it?

Taxation without Legislation

“Inflation is taxation without legislation.” -Milton Friedman

Inflation is the relative price of a certain set of goods in relation to a particular currency.  In our case, we are concerned with the price of goods in relation to our old pal the greenback.  Inflation is *NOT* the CPI, or the increase in price of oil, or any other indirect proxy the media holds up and declares as inflation.

What causes this inflation?  There is a general consensus among economists that inflation is linked to an increase in the money supply.  There are multiple ways to define ‘Money Supply’, and in the United States, they are M0, M1 and M2 (and previously M3, which now only has private estimates).  For an overview of the various categories of money supply, see this Wikipedia entry.

The Relationship of Inflation to the Money Supply

Inflation is linked to the money supply by the equation

V*M = P*Q

V = Velocity of Money (time it turns over)

M = Money in the money supply

P = Average price of goods

Q = Quantity of goods purchased.

In the above equation, ‘P’ is the variable linked to inflationary changes.  From the equation you can see that the turnover of the money supply is important to the inflation caused.

The Recent Increase in the Money Supply of the United States

It’s not a secret that the United States has recently set out down a path of massive deficit spending.  Coupled with the deficit spending has been a huge increase in the supply of money.  The reason we haven’t (yet?) seen inflation is because this increase in the money supply happens to be at a time of low velocity of money (a Recession).  A bet against inflation (or even deflation) is a bet that the Federal Reserve can dial back the stimulus at the point when monetary velocity starts increasing again.  Do you have faith they can do that?

Measurements of Inflation

In America, the main measure of inflation we use is the Consumer Price Index (CPI).  The Consumer Price Index is a monthly measurement of the price of a number of representative goods, with each assigned a relative weighting in the basket.  At the point that goods change, (for example, with new technology) the former good’s place in the basket is replaced with a comparable new good.

You can find the CPI index at the Bureau of Labor Statistics, which will report the CPI for every month since 1913.  Recently, the CPI has reported inflation at -.1% for March, 0% for April, and .1% for May.  The last three month reported compund inflation is -.2%.  Interesting…

Using The Market to Gauge Inflation Expectations

There is a simple way to see what the market expects in terms of inflation.  The government issues debt to pay for its deficits and current spending.  The Treasury Department publishes indexes for the yield curve and the ‘real yield curve’ (the TIPS curve, or Treasury Inflation-Protected Securities, which is the return above inflation).  Simply finding the difference between the two expectations gives an approximate estimation for the future inflation expected by the market  (Although sometimes it isn’t a perfect proxy… see this post by Greg Mankiw).

What do the figures say?  I graphed the following chart which will show you the markets inflation over the next 5, 7, 10, and 20 years.  The number is the annual inflation rate.  For a description of the figures and how they are attained, see this description.

Predicted Inflation (Using Treasury Yield Reports)

As you can see, the market is predicting pretty tame inflation over the next 5 – 20 years.  This could be a vote of confidence in the ability of the Federal Reserve to react at the proper time to inflationary pressure- or the market may not be as efficient as some people believe.

And Now, What to Do About It

Do you have an opinion on whether the extraordinary efforts undertaken in the market will cause inflation (or fail to fight off deflation)?  There is a way to play it in the markets.

If you believe inflation will be less than the market is predicting, you predict the yield spread will contract.  This means the price of TIPS will decrease and/or the price of treasuries will increase (Prices and yields move in opposite directions).  you could short sell TIPS and go long Treasuries.  Alternatively, you could bet the opposite and go long TIPS and short Treasuries.

If you are against hedging using short options, you can invest in mutual funds which are proxies for short and long trades.  Search for Bear Market Bond ETF to find the ETFs of the proper maturity.  Alternatively, you could just buy one side of the trade.

Stocks, historically, have also been a great hedge against inflation.  Here is an article discussing this phenomenon.

You can invest in currency ETFs, which will bet for or against a currency versus a basket of other currencies.

Another option is to bet for or against commodities.  It is probably best to invest in a basket of commodities to hedge against any single commodity risk.

Any way you look at it, monetary policy is hugely different from any time in history.  Is the unprecedented expansion in the money supply an actionable event?  Should you prepare for bouts of inflation or crippling deflation?  It’s up to you.  Opinions vary, but personally, I feel the stimulus will be removed too soon and inflation is in the cards.  Happy Investing!

Inflation thumbnail sourced from www.flickr.com/photos/78042080@N00/3238458006.
http://gregmankiw.blogspot.com/2008/12/real-interest-rate-plunge.html
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