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Protect Yourself from the Fed’s “Inflation Delusion” with This

Money Morning Contributor
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The U.S. Federal Reserve has kept interest rates stuck near zero for the last seven years, so there’s little wonder investors and savers feel like “perma-zero” is the new paradigm.

Despair and ennui have settled in. According to the Fed, some 31% of non-retired Americans have no savings or pension whatsoever.

Some have been frozen out, unable to save thanks to stagnating incomes and dismal job prospects. Others who might otherwise be able to save just don’t see the point when they’re not making any interest to speak of.

That negative outlook is understandable, given today’s economic realities. But it doesn’t have to be that way.

Not when a small investment in one easy-to-buy asset can make so much difference.

Anyone Can Fall Into the Trap

Recency bias in investing is basically the tendency to assume that recent trends and behavior are likely to repeat in the future.

That typically works fine to predict the very near term, but the farther out one’s timeline, the less reliable it tends to be.

It’s one of the biggest reasons why the investing crowd is usually wrong, and it’s all too easy to fall for.

It’s bad for investors, but when policymakers like the Fed’s Federal Open Market Committee (FOMC) fall into this trap, there can be consequences for everyone.

For instance, St. Louis Fed President James Bullard thinks America may be, according to Reuters, “entering an era of permanently low rates and inflation that will require a rethink of monetary policy.”

He told attendees at a Cato Institute conference that “should we find ourselves in a persistent state of low nominal interest rates and low inflation, some of our fundamental assumptions about how U.S. monetary policy works may have to be altered.”

According to Bullard, zero rates may become a permanent fixture, which could lead to higher market volatility, along with pressure to make quantitative easing (QE) a Fed policy norm.

Fed Chairwoman Janet Yellen herself highlighted the need to assess the unconventional monetary policies employed by central banks worldwide as they reacted to the global financial crisis of 2008.

There is, however, the odd hawk…

Fed Vice Chairman Stanley Fischer told a conference of researchers and FOMC members that “some of the forces holding down inflation in 2015, particularly those due to a stronger dollar and lower energy prices, will begin to fade next year.”

And Chicago Fed President Charles Evans recently told reporters after a presentation to the Manufactured Housing Institute in Chicago that he’s been dumbfounded by the lack of change in the inflation outlook, despite a strengthening U.S. economy.

To his credit though, Bullard did say that the Fed’s near-zero interest rate policy was subjecting the American economy to “considerable risk of future inflation.”

And so from these remarks, we can see real signs that the Fed itself is falling victim to recency bias with respect to interest rates and inflation expectations.

The market itself is pointing to a real risk of deflation, with oil and commodities especially weak.

But as you’re about to see, real interest rates may actually be lower than you think.

Thinking Differently About the Problem

Peter Schiff is an outspoken financial analyst who’s not shy about taking a hard look at economics and politics.

According to Schiff, the Fed may have already started the tightening cycle… as far back as a year ago.

He refers to a financial model constructed by University of Chicago professors Cynthia Wu and Fan Dora Xia called the “Shadow Rate.”

The Wu-Xia model accounts for the Fed’s forward guidance and quantitative easing, whereby the Fed attempts to manipulate expectations in order to push rates up or down, depending on its goals.

the fed
As you can see from the Shadow Rate model, the Fed funds rate headed much lower from mid-2009 until early 2014, to effectively reach below zero at -2.99%.

At that point, the Fed began talking about tapering QE which, for the past year and a half, has had us in a tightening cycle, with the model currently still pegging rates below zero.

Judging by the stock market’s lack of returns and volatility since, it’s not clear whether this is what the Fed actually intended.

One way or the other, should the Fed continue on the path of tightening (which may be the case, especially if they follow through with a rate hike this December), stocks may simply be unable to tolerate that and could go into convulsions.

Odds are that would be enough for the Fed to bring the QE punch bowl back again and again, spiking it more with each reiteration.

It’s worth mentioning that Ben Bernanke, Yellen’s immediate predecessor, was a student of the Great Depression. He concluded that it was made worse because the Fed failed to print enough money, choosing rather to tighten.

Back in 2002, Bernanke even apologized to economists Milton Friedman and Anna Schwartz, vowing the Fed would never allow that to happen again.

The Fed is paranoid to the core of deflation ever taking root. That would cause the federal debt to just grow larger and become more onerous. So inflation will be created, come hell or high water, along with all its effects, intended and unintended.

Sadly the result will be, as economist Ludwig von Mises explained, a “crack-up boom” to end all booms. Average people will realize how worthless their dollars have become and will rush to spend them on virtually anything of value.

As I’ve noted before, fiat money will become the “barbarous relic.”

Here’s Your Protective Play

Your insurance against this outcome is simple. Own gold.

Right now, it’s still cheap.

Be sure to have at least some physical gold, whether in the form of coins or bars. If you want to complement that with an exchange-traded fund (ETF), consider the Sprott Physical Gold Trust (NYSE Arca: PHYS).

The trust holds gold bullion that is fully allocated and stored at a secure third-party location in Canada, subject to periodic inspection and audits.

Right now, PHYS shares trade at a -0.63% discount to net asset value. But there are other compelling reasons to own this fund:

  • No middle man: Unlike most gold ETFs, no levered financial institution stands between investors and the physical gold. This means no risk of financial loss in the event of bankruptcy or nationalization of the financial institution.
  • Lower taxes: U.S. investors who hold shares for at least a year pay capital gains tax at a rate of only 15% versus the 28% rate for most precious metals ETFs and physical gold coins.
  • Ability to trade in shares for physical gold: Investors who hold a required minimum amount can redeem units for physical gold bullion on a monthly basis. Gold bars can be delivered by the custodian almost anywhere in the world via secure armored transport.

Remember, your best protection against the eventuality of a “crack-up boom” is gold. And the time to buy insurance is before you need it.

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