It is not a question of “if” inflation is coming, but when. The Federal Reserve (“FED”) is setting the stage for inflation. In 1977, the FED was given a second mandate of full employment in addition to its first mandate of price stability. These two mandates can run counter to each other. Congress gave the FED this second mandate because of the poor economy in the late 70’s. In order to try and regain full employment, the FED had an easy monetary policy in the early 80’s that caused significant inflation. Paul Volker addressed this by raising interest rates to over 20%.

The FED is doing the same thing today. It has a target unemployment rate of 6.5% before they will contemplate raising interest rates. To accomplish this, the FED has been pumping money into the system at an alarming rate. Over the past 4 years, the money supply has expanded by more than 50% through lower interest rates and unprecedented FED purchases of securities – which it buys with money it prints. The only reason inflation has not hit yet is that the velocity of money – how fast money turns over in the economy – has dropped to its lowest level in more than 50 years. Once velocity picks up, inflation rises.

The FED says it can handle future inflation by selling assets or raising interest rates. This is true, but does not consider the ramifications to the federal deficit. We believe the FED will have a harder time fighting inflation in the future because of the debt levels of the Federal government. If interest rates rise by just 2%, the annual deficit will go up by at least $340 billion – current debt of $17 trillion multiplied by 2%. Many people are focusing on when the FED will start tapering its asset purchases. That is important, but the policy will still be easy with 0% interest rates until 2015. The FED is playing a dangerous game that ultimately will lead to higher inflation.

Because of the prospect for higher inflation, it is imperative to have a portion of one’s portfolio tied to hard assets. We don’t know when inflation will come. When it does come, the FED will have a hard time fighting it and will probably persist for a longer time due to the debt the government has accumulated.

Sincerely,

Your THOR Team