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3 Inflation Myths You Need to Know

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These days, it's popular to be scared of inflation. And rightly so. But if you're to stay ahead of a falling dollar, it's essential to distinguish inflation myth from reality.

Forget what you know -- partially
Below, I've summarized three myth-busting insights recently penned by John Hussman, economist and market-beating fund manager. Spoiler alert: Stocks may not live up to their reputation as championship inflation fighters.

Myth No. 1: Expanded monetary base = inflation
With the Fed having run the printing presses 24/7 since the financial crisis hit, the dollar by definition must be poised to shed value, no?

Not necessarily. Hussman shows that changes in the monetary base and inflation do not always move in lockstep. Look at the 1950s. Or, better yet, take present-day circumstances, where inflation is running at an annual 2.7% (hardly nefarious), even as the monetary base roughly doubled in recent years. Gold bugs, what say you?

Depending on macro conditions, one of several possible scenarios could explain the correlation gap. Today, we might do well to note the difference between the monetary base, which the Fed controls in the form of bank reserves, and the actual money supply in the real economy, which is primarily determined by discretionary bank lending.

A more consistent inflationary trigger, offers Hussman, is government spending.

Allowing for a time lag, changes in government outlays and inflation have historically shown remarkable correlation. Saying hmmm yet?

Hussman explains that as the government aggressively spends, it creates a "relative scarcity of goods and services outside of government control," driving up private-sector costs. Concurrently, the supply of Treasuries rises in order to finance the spending spree, in turn sparking debt-driven concerns and pressuring the dollar.

The result? Inflation. But not because of the usual suspects. As Hussman quips, "the primary determinant of inflation is not monetary policy but fiscal policy."

Ultimately, while the dollar might strengthen relative to even weaker currencies, the current level of U.S. borrowing indicates that the greenback may nonetheless depreciate relative to other stores of value, namely, hard assets. Hence, investors who have been pouring money into SPDR Gold Shares (NYSE: GLD  ) and iShares Silver Trust (NYSE: SLV  ) , or miners such as Newmont Mining (NYSE: NEM  ) and Agnico-Eagle Mines (NYSE: AEM  ) , may indeed be proven correct over the long term.

Myth No. 2: High unemployment and low wages = deflation
This notion is quickly undone. Basically, some argue that generally lower prices will persist so long as we have high unemployment and excess manufacturing capacity. Now, it's true that the latter situation describes low private-sector demand, but Hussman has already shown that the private sector isn't the only variable in the inflation equation.

In fact, based on historical data, elevated unemployment is more strongly correlated with higher rather than lower inflation. Insofar as the government has traditionally attempted to combat unemployment with spending programs, that relationship should sound familiar.

Myth No. 3: Stocks = effective inflation hedge
While it may be true that equity returns run ahead of inflation in the very long term, stocks won't always provide immediate shelter from inflationary spikes. Just take a look at the table below.


Average Change in CPI

S&P 500
Total Nominal Return


































Data from Bureau of Labor Statistics and Standard & Poor's.

Citing pendulum swings in sentiment, Hussman explains, "Investors tend to systematically elevate P/E ratios when inflation rates are low and depress P/E ratios when inflation rates are high."

Importantly, investors who bail on stocks as inflation jumps aren't as capricious as you might think. In reality, companies often can't increase prices on par with accelerating costs. For just two examples, look to the most recent stretch of escalating commodity costs, where price increases taken by consumer-goods companies General Mills and Kimberly-Clark (NYSE: KMB  ) drastically lagged expenses. The disparity persisted for years, not just a few quarters.

Consequently, stocks aren't always an effective inflation hedge.

So what's the strategy?
Beating inflation year in, year out isn't easy. Pursuing multiple strategies, however, should help. Refusing to pay up for stocks when they're expensive is a good starting point. Also, a healthy dose of Treasury Inflation-Protected Securities (TIPS) could help power your portfolio ahead of a falling dollar. Globally geared companies such as Philip Morris International (NYSE: PM  ) also make sense -- provided the dollar doesn't become a "best of the worst" among fiat currencies.

As for gold, the yellow metal is probably best classified as an excellent speculation rather than a sound investment. But if you are going to go for the gold, knowing that events such as monetary base expansion don't necessarily presage inflation, may help you avoid investing at sentiment-driven tops.

Personally, I prefer oil, which has both consistently rallied in response to inflation and is more easily valued. Although there's certainly company-based risk, high-quality E&P names such as Petroleo Brasileiro (NYSE: PBR  ) and Anadarko Petroleum are definitely worth a look.

Finally, simply distinguishing inflation myth from reality will help prevent you from reacting in step with the masses. And that alone should improve your profits -- both nominal and real.

Philip Morris International is a Motley Fool Global Gains pick. Kimberly-Clark and Petroleo Brasileiro are Motley Fool Income Investor selections. Try any of our Foolish newsletters, free for 30 days.

Fool contributor Mike Pienciak holds no financial interest in any company mentioned in this article. The Fool has a disclosure policy.

Read/Post Comments (9) | Recommend This Article (26)

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  • Report this Comment On February 03, 2010, at 3:29 PM, FleaBagger wrote:

    With all due respect, I want to see some evidence that an expanded monetary base is ever correlated with slower government spending growth. On the contrary, an expanded monetary base is precisely what causes asset bubbles in the private sector, first of all, and inflation of prices and increased government spending during the "reflation" period. All data indicate that we are headed for stagflation and a gangbusters period for gold.

  • Report this Comment On February 03, 2010, at 3:32 PM, FleaBagger wrote:

    Oh, and considering that government is responsible both for paying the interest on TIPS and for determining which factors are relevant for the CPI, I wouldn't bank too heavily on TIPS providing a positive real return if (or I should say when) stagflation gets really ugly.

  • Report this Comment On February 03, 2010, at 4:33 PM, dyadco wrote:

    Interesting article.

    Your sentence: "Ultimately, while the dollar might strengthen relative to even weaker currencies, the current level of U.S. borrowing indicates that the greenback may nonetheless depreciate relative to other stores of value" says it all to me.

    Sure, gold, oil, TIPS may be a way to go, but I feel that investing in the major global companies currently based in the US are the best defense against inflation AND deflation of the $US for the simple reason that these companies don't have to remain domiciled in the US and can move off shore to take advantage of other tax regimes, and at the same time lower their dependence on the $US whilst gaining exposure to stronger currencies and markets.

    I may be right off the mark and the future may prove my actions were ill advised ( and I have to take responsibility for that) but thats what I am doing.

  • Report this Comment On February 04, 2010, at 2:47 PM, ET69 wrote:

    As for the comment about '"relative scarcity of goods and services outside of government control" drives up private sector costs ----- can you expound a bit on that ? I am not sure I follow. Thanks

  • Report this Comment On February 05, 2010, at 4:42 PM, rfaramir wrote:

    "Expanded monetary base = inflation" This is the proper definition of inflation. If you mean price inflation, then you are correct that it does not immediately hold true. The newly printed dollars do not flow to all current dollar holders evenly. Banks may get them first, then whatever the bankers or speculate on next, then whatever those receivers purchase next, and so on. Those who receive the new dollars first see NO inflation for a short while, spending their legally counterfeited dollars at the cost of all the rest of us who get them much later. Most of us see inflation eventually rise (and our dollars spending power diminish) as all those new dollars chase the same number of goods long before we are the recipient of any new dollars filtered through the whole economy.

    "Stocks aren't always an effective inflation hedge" is a straw man argument that essentially means that stocks are usually a pretty good inflation hedge. Finding a new and useful "always"-based statement could make you very rich indeed.

    High unemployment is caused by government interference in the free market, usually by enacting minimum wage laws or enabling unions to do or threaten to do things that are illegal for anyone else to do, such as forcibly occupying someone else's private property. An unrestrained free market has essentially 100% employment.

    Deflation is the free market's way of increasing everyone's real income by making products cheaper to make and to sell. Division of labor, deployment of capital, and technical breakthroughs all enable this and are characteristics of a free market.

    Read up on all this at

  • Report this Comment On February 06, 2010, at 7:07 AM, kaskoosek wrote:

    Buying TIPS is retarded.

    How can I buy insurance against a certain company going bankrupt from the company itself. It is not logical.

  • Report this Comment On February 12, 2010, at 1:50 PM, Classof1964 wrote:

    It is important for economic arguments to have both theory and a knowledge of history. "HIgh unemployment is caused by government interference in the free market." hmmm. . . The 1920s, laissez-faire epoch controlled by Republicans; then 2001-2008, mostly Republican control or all three branches (until 2007 re Congress), but still little government regulation of economy despite laws and agencies/departments that were supposed to regulate. Result 1929- , 2008- high unemployment.

    "an unrestrained free market has essentially 100% employment." Definition of that "free market" ?? and a concrete historic example????

  • Report this Comment On February 12, 2010, at 1:56 PM, Classof1964 wrote:

    It is essential to have a knowledge of economic history as well as one of economic theory. "High unemployment is caused by government interference in the free market. . . " hmmm . . . 1920s, laissez-faire period, Republican control of federal government; 2001-2008, Republican from far right as President, Congress Republican until 2007, federal departments and agencies run for whole period by appointees who despite laws and powers of same regulated as little as possible. Result high unemployment 1929-, 2008-.

    100% employment in an unrestrained free market: ??? Definition of such a market?? A concrete, historic example ???

  • Report this Comment On June 04, 2012, at 8:23 AM, StopPrintinMoney wrote:

    Author - Should've posted this article joke on April 1st, so it'd make more sense.

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