Watch Out for Inflation

This is a guest post by Simit Patel, a contributing analyst at InformedTrades.com, a site that offers free courses on trading the world’s financial markets.

At the time of this writing — December, 2008 — the US economy is characterized by deflation. Deflation means the supply of money is falling, the value of currency is rising, and asset prices are declining. In times of deflation, it’s often best just to pay down your debts and save your cash.

By the end of 2009, however, the economy might be very different. In fact, many economists, myself included, are more concerned about inflation towards the end of 2009 and through 2010.

Why inflation may increase in the coming year

1. The US government continues to amass more debt. The bailouts that have been promised and continue to be promised, as well as entitlement payments in the form of social security and unemployment, are coming at a time when the tax base is diminishing. The result will be a need to finance this via the issuance of debt — i.e. US Treasury bonds. The key question, though, is who is going to buy this debt? Foreigners, particularly China, have been big buyers of US Treasuries. But the economic problems have been a global issue, and thus the appetite for US Treasury bonds may be diminished — particularly when rates are low.

If the US government cannot find buyers of its debt, it will simply need to print the money. This will increase the likelihood that the money existing in supply will be devalued, so that it will take more dollars to buy the same amount of goods and services. This concern is one of the reasons some economists were particularly opposed to the bailouts that have been promised.

2. Worldwide uncertainty. As the recent events in Mumbai have shown, the world is still in a time of great tension. President-elect Barack Obama has already voiced concerns about Pakistan, and has stated the US military may need to position troops there. As the world is very interconnected economically, countries can attack in ways that do not involve soldiers. For instance, many US dollars and US Treasury bonds are now held by foreign central banks. Those central banks can thus wage “economic warfare” by selling bonds and US dollars, which will result in decreased demand for US dollars and a greater supply of them on the market. Such a scenario will devalue the US dollar.

The central banks of China and Iran have recently both increased their holdings of gold. Whether they are waging economic warfare or simply holding more gold, the result is the same: evidence of a decreased demand for US dollars.

How Can You Protect Yourself?

You don’t need to fear inflation, but you do need to be aware of how you can protect yourself against inflation.

To protect yourself financially, consider three things:

1. Hedge against currency devaluation. As anyone who lived through the inflationary depression of Argentina in 2001 can tell you, gold and silver are great ways to preserve your wealth, and historically have been great hedges against currency devaluation. Since the US dollar has lost much of its value since 2001, gold has risen in value as well.

2. Buy durable goods. As the value of your currency may be dropping, now is actually a good time to buy. If you are planning big purchases over the next few years, it may be worth considering purchasing them now if you can afford to do so.

3. Don’t prepay long term debt. Just as you should consider buying real goods now, it may also be worthwhile to delaying payments on debt — especially if your debt is at a fixed interest rate, and if you can afford to do so. It will be to your advantage to pay your debt back when the currency is worth less, as you will have bought while the currency was more valuable then when you paid the debt back. This strategy is a bit more risky, though, and thus you should be careful before trying it  — consider your personal wealth and the terms of the debt carefully before taking part.