Inflation vs Hyperinflation

So what are we looking at, here?

This chart shows that we have increased the money supply by over 10x in just one year. For those who may not remember, the money supply is the amount of dollars that are in the economy. In our current system, each dollar is only worth what the open market is willing to pay for it. There are two reasons why people and businesses would want to own dollars.

First, people use dollars for commerce. That is the easiest part of demand to understand. What to buy something in the USA? You'll need dollars. Want to buy something from an exporter based in the USA? You'll need dollars.

The second part of dollar demand is called "interest rate parity." This concept is simply common sense. Imagine that you, my reader, are a business executive in Europe and you need to find a safe place to invest some of your currency. Suppose that your home country offers an interest rate of 4% on its government bonds. Now imagine that US Treasury bonds offer an interest rate of 6%. Would you prefer the US bonds? Of course you would. So you would trade your Euros for dollars so that you could buy US bonds. This increase in demand for dollars would cause the value of the dollar to rise. Conversely, if US rates are lower than they are in other countries, then people would prefer to trade dollars out for Euros (or whatever currency applies), which would cause the value of the dollar to fall. That's how interest rates affect the dollar's value.

There is one more piece of the puzzle we need to understand before we can make sense of the the chart above. Both of the above concepts are simple to understand if the number of dollars available remains steady. This was one of the lessons economists thought we had learned from the Great Depression. Instability in the money supply makes it extremely difficult to accurately price goods, services and investments.

Here's why: imagine that our entire economy was comprised of 100 apples and we had 100 dollars to use for trading them. Each apple would be worth $1. Next, imagine that we decided to print 100 more dollars. Now, we have 200 dollars to account for 100 apples. How much is each apple worth, now? The answer is $2, of course. The orchard owner just grew his little economy from a $100 to a $200 one. But he didn't do a thing to actually increase production. He still only has 100 apples. All he did was create inflation.

You may by thinking this is a pretty foolish thing to do. I agree. It would be even more foolish if our apple farmer increased his dollars from 100 to 1000? You would need $10 just to buy an apple. Anyone who kept their money in a savings account or under the pillow would become destitute. But those people who bought apples would come out winners. And those people who invested in apple trees would become tremendously wealthy.

Take another look at our chart. Our government has increased the money supply at the same rate as our farmer. If interest rates remain constant, we are looking down the barrel hyperinflation (rates above 100% per year). To control this, the Fed is going to need to raise interest rates dramatically. Even with this band-aid, we might avoid hyperinflation but chances are very good that investors will still need to find ways to combat historically high inflation rates.

Log in tomorrow for our discussion on what type of investments we are using to turn the tables on inflation and make this a profit opportunity for our clients.