We are now at an historic inflection point in history—with no turning back the clocks. Had our political leaders from Reagan and Clinton to Bush I and II been more fiscally responsible, we wouldn’t be facing the largest monetary storm in history. That monetary storm lies directly in front of us. Bernanke and Greenspan may summarily dismiss high oil prices, but for most of us who live in the real world, higher energy costs are going to be inflationary. Investors need to start preparing for $100 oil. Higher oil prices will eventually permeate all aspects of economic life, driving the costs of basic necessities higher. In the future you may be able to buy a flat screen TV, DVD player or personal computer at a cheaper price, but the cost of everything else will be rising. The things that you need in everyday life will all be going up: your grocery bill, your utilities, the gasoline that powers your car, visits to your doctor or dentists, tuition, and lastly, taxes.
The economy will vacillate between periods of deflation and inflation, with each recession bringing forth a temporary reprieve from what will be an inexorable rise in the general rate of inflation. Eventually wars, deficit spending, a rising mountain of debt, and peak oil will lead towards hyperinflation in the United States.
Already, the U.S. is exhibiting many of the pre-hyperinflationary conditions that are so prevalent in many South American and Eurasian economies. Evidence points to several factors that will lead us there:
Large budget deficits
Deteriorating international trade balances
An eroding international currency
Eroding financial confidence
An expanding war on terrorism and the need for security
Whether the U.S. experiences hyperinflation or simply higher inflation rates will be dependent on the political will of its leaders to rein in spending and bring its fiscal imbalances into order. At this point, it appears hopeless with over $51 trillion in unfunded Social Security, Medicare, and pension liabilities now growing at over $2 trillion a year. History teaches us that debt imbalances of this magnitude are always inflated away.
An expanding money supply, abundant credit, and negative interest rates are inherently inflationary. When investors realize that they can borrow money at next to nothing rates and invest that money in hard assets and get an immediate return, the demand for such assets rises. This leads to higher prices, asset bubbles or inflation. This is what is going on now in the financial markets, the real estate market, and in the commodity markets. A flood of money and credit throughout the world is driving asset bubbles and inflation. Central banks can create money and credit, but they are unable to direct where that money flows. One of the chief characteristics of inflationary cycles is asset bubbles. First, it was stocks in the 1990s. Then, it was real estate and mortgages in this new century. It is now working its way through to the commodity markets. The new bull market in commodities will dominate the financial markets the balance of this decade and the next.
As debt levels rise in the U.S. at unprecedented levels, the Fed will increasingly become impotent. Unlike Volcker in 1979, today’s U.S. economy is far more debt laden. Because of this huge debt overhang and the huge asset bubbles that support it, the Fed’s options are limited. The Fed simply can’t afford to raise rates in the same decisive and single-minded way that Volcker did during 1979-1982. The Fed’s new mantra is "measured." This means that real interest rates will remain negative for a long period of time.
No matter how high inflation finally gets, it is abundantly clear that the financial markets are undergoing a paradigm shift from a bull market in paper to a bull market in commodities or "things" as I like to call them. Investors will need to focus on a different class of assets. Real assets are going to be the big winners in this new emerging bull market. Commodities are becoming "The Next Big Thing." Precious metals, base metals, energy, water, and food are where the next fortunes are going to be made. Precious metals have, will, and are going to lead this new bull market. It is in regard to precious metals that I devote the remainder of this essay.