Hyperinflation, when a nation's rapidly devaluing currency causes runaway price increases, can be a real disaster. Recently in Iceland, it led to some bizarre behavior.
But the threat of hyperinflation is not the primary concern for policymakers at the moment. The recent announcement that Bank of America (NYSE:BAC) will need an additional $34 billion in capital is just another glaring reminder that the banking system is still fragile. With less money changing hands, we remain in the midst of one of those dreaded 'D' periods, and it's not a depression.
The 'D' word
Deflation, a condition where general prices keep falling, is currently the bigger concern. In a deflationary environment, consumers and businesses delay investments and purchases because they believe they will be able to get the same goods and services at a lower price in the future.
The recent crash in housing prices spread to the financial markets, where the appetite for mortgage-backed securities and lending evaporated. Now, businesses and consumers are cutting back on investments and purchases. If left unchecked, it could spiral into a long-term period of depression like the one in the 1930's.
Fire up the presses!
To combat the possibility of such a deflationary spiral, the Federal Reserve has been injecting capital into banks and buying assets to stabilize prices and help leveraged financial institutions unwind their obligations so they can resume lending.
But this extra liquidity in the system has created the potential for a hyperinflationary episode in the coming years. As a result of the bank bailouts, the monetary base, the total of cash in circulation plus bank reserves, more than doubled over the past year. Here is the St. Louis Fed chart if you dare.
However, the monetary base is not the only factor in calculating the rate of price increases. The velocity of money, the rate at which money is spent in the economy, is a consideration. When it comes to velocity, the Fed can control inflation by raising interest rates, which in turn sucks liquidity back out of the financial system once inflationary pressures start to become apparent.
If policy makers are wise, they can prevent Zimbabwe-style inflation, which at one point last year approached 80 billion percent. I believe hyperinflation is something the U.S. will avoid, and we won't ever buy loaves of bread with wheelbarrows full of money. That said, you will still want to hedge yourself against the dollar's possible devaluation.
How you can do that
Currently, the flight to the safety of the dollar has led to its short term strength. This, along with a cooling world economy, has contributed to the commodity price collapse. But both the U.S. and China have massive stimulus packages in the works, and commodity prices should rebound sharply in the coming years as demand comes back. Freeport-McMoRan (NYSE:FCX) and Southern Copper have already more than doubled off their lows and should climb higher if metal prices continue to rise.
And oil, which is priced in dollars, will likely rise if the dollar weakens. Higher crude prices will not just benefit majors like Exxon-Mobil (NYSE:XOM) and Chevron (NYSE:CVX), but will also provide incentive to extract oil from costly deepwater fields. For this reason, I am also bullish on oil service majors like Transocean (NYSE:RIG) and Diamond Offshore. Even Dryships (NASDAQ:DRYS), which just inked a $630 million deal with Petrobras (NYSE:PBR) is a nice under-the-radar play in the offshore drilling sector.
Finding value
Even with the recent run-up, the market is still priced in deflation mode with plenty of long-term value to be found. Our Motley Fool Inside Value team is right now picking stocks in quality companies that are currently priced for the short term, but have incredible long-term potential. They recently identified their 10 best buys for new money. You can see them all – including two energy picks – with a free 30 day trial. There's no obligation to subscribe.
Fool contributor Matt Hoffman's favorite commodity is, by far, tungsten. He owns shares of Dryships and Freeport-McMoRan. Petrobras is an Income Investor recommendation. The Motley Fool has a disclosure policy.
