Inflation is a tax upon everyone who saves. While your money may be safely locked up in a bank vault, the actions of the Federal Reserve, which has been flooding the economy with currency, may well be slowly wiping it away. Soon it may not be all that slow.
The Federal Reserve, which is a corporation formed by the large banks with a Chairman appointed by the President, has the ability to create ir destroy currency at will. (Note, “currency” in this case means the number of dollars available to be spent, as opposed to wealth which can only be created when someone creates or finds something of value to another person.) If you add up all of the cash in people’s pockets, the balances of their bank accounts and in corporate bank accounts, and the money held in the banks available for loans, it is called the “Money Supply.” The Federal Reserve, at the stroke of a key, can add or remove money available for loans, thereby changing the Money Supply. They can also produce money to buy things like long-term Treasury notes or mortgage-backed securities, which they have been doing for some time. This also puts more money into the economy.
The Federal Reserve is supposed to use their power to create growth in the economy while limiting inflation. When the Federal Reserve creates currency, it provides more funds for banks to loan which can help spur the economy, but it can also create inflation since it is increasing the number of dollars available without increasing the amount of value in the economy. When the Federal Reserve withdrawals funds from the economy, it can slow inflation by reducing the number of dollars available, but it also reduces the amount of credit available and increases interest rates, which can cause a recession.
For a long time the Fed has been creating money in an attempt to cause the economy to pick up speed, but there has not been a big demand for loans and the banks are requiring strong credit before they will make loans. Eventually, when the economy starts to pick up and businesses decide to expand again, all of this money could come flooding out into the economy, leading to high inflation. We have already seen inflation in gas prices, food prices, and gold. The lack of spending and the depressed home market has restrained prices in other areas, but this will not last forever.
One of the best ways to combat inflation is to place money in assets such as real estate and stocks. While the value of any given piece of property will be influenced by local conditions such as the amount of crime and new businesses that are built in the area, overall the value of property will be about fixed. This means that the price of land, in dollar terms, will increase at the rate of inflation. This is because the things that can be produced by the land, like crops or sales, will increase in value with inflation as well. One will also be able to charge more for rent for an apartment if people are paid more dollars. Likewise, if a home is located on a place with a great view, people will be willing to pay more dollars for the home when they are paid more dollars at work.
Equities (stocks) are an even better inflation hedge because they will grow profits with time along with seeing the number of dollars they collect grow due to inflation. If there is inflation, forcing businesses to pay more for goods and employees, they can raise the prices they charge. They can also open more locations or increase the number of items they sell. Land does not become more valuable with time (in relative dollars) unless there are changes in the local conditions.
A final hedge against inflation is to buy foreign stocks. If the value of the dollar declines against the Euro, for example, the profits of foreign companies will increase in dollar terms, and the dividends they pay in dollars will increase. Likewise, their price of the shares of the foreign company will increase in dollar terms. One should spread the money over different regions when investing internationally since there can be the risk of inflation in other countries as well, along with unique risks such as government actions and political instability.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.