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Posted on March 11, 2017

Retirement Investors: Beware the Inflation “Whipsaw Effect” of the Stimulus Package

Right now, the last thing most investors are worried about is inflation. The price of almost everything, from real estate to stocks to mutual funds, is going down. If you want to get more for your money, all you have to do is sit back and wait until even better bargains come along. In other words, we are experiencing deflation. There are, however, indications that this situation may be short-lived, and that inflation may soon once again rear its ugly head.

The recession that we’re currently experiencing has been more painful for more Americans than any other economic slowdown since the Great Depression. Not only have many lost their jobs—tens of millions have lost a big chunk of their retirement savings, and even their homes as well. And more people than ever before are struggling under enormous loads of debt. For them, even a minor economic setback can spell disaster.

President Obama was elected on campaign promises of “change” and “hope.” The expectations placed upon him are high. If he wants to have a chance at re-election, he has to deliver on his promises. So he’s making an earnest attempt. It’s called a “stimulus package.”

The “stimulus” essentially consists of a diverse bundle of government spending programs to the tune of at least a trillion dollars (that’s $1,000,000,000,000.00). Where will such an astronomical sum come from? According to official statements, the President intends to increase the deficit—in other words, the national debt. This means that the government will borrow the money it needs.

But from whom? Who is going to pony up a trillion bucks, and hand it over to Uncle Sam in exchange for an IOU (i.e., government bonds)? Foreign countries such as China, Japan, and Saudi Arabia are already big lenders to the U.S. government. And they’re experiencing recession, too. Their ability to lend is just about tapped out. Domestic lenders are also at the end of their ropes. Trillions of dollars have been wiped out in the stock market and real estate crashes. Is there anybody left?

Though official spokespeople don’t like to talk about it, there is one institution that is capable of putting up the money. It’s called the Federal Reserve. When the “Fed,” as it’s commonly known, wants to either (a) make credit more easily available or (b) stimulate the economy, it buys up debt instruments such as bonds using money that it essentially creates out of thin air. That money then goes into circulation. Some if it ends up in the “reserves” of commercial banks, who can then re-lend it, causing a “multiplier effect” resulting in the creation of even more new money.

Once the “stimulus package” is implemented, and the government begins its spending spree, the economy will indeed start to recover. More money in the hands of businesses and individuals will mean more consumption, more investment, more jobs, and more income. At least some of the pain of recession, maybe all of it, will be relieved.

But as all that newly minted money surges through the economy, and is multiplied through repeated lending and borrowing, prices will be driven up. The glut of dollars will drive the exchange rate down, making foreign goods more expensive. And unfortunately, most of what Americans consume are “foreign goods.” When was the last time you bought a shirt, a chair, or a toothbrush “made in USA”? You can’t even buy a U.S.-made TV or DVD player because none are manufactured here. As prices for foreign-made goods surge, Americans will have to send even more dollars overseas to get their goodies, which will make the dollar glut even worse. Not a pretty scenario.

As if this weren’t bad enough, inflation of this kind inevitably drives interest rates up. After all, if money is worth 10% less every year, lenders have to get at least 10% in interest just to break even. This will have two very unpleasant effects. First of all, even though the value of money will be going down, real estate prices will drop, since homes will become less affordable as mortgage rates surge (this happened during the great inflation of the late 1970s). Second, because bonds will be paying high interest rates, stocks will have a hard time competing. A dividend yield of 5%, which looks attractive right now, will appear paltry compared to 10% or 15% yields on bonds. This will cause stock prices to drop, further battering beleaguered 401(k) plans and other retirement investments.

So what’s a future retiree to do? This complex situation cannot be mastered through simple “buy and hold” strategies. Now, more than ever, it is essential to carefully monitor the economy. At present, while the outlook is (temporarily) deflationary, cash investments, such as short-term high-quality bonds, are an excellent investment. But stay away from long-term bonds: the last thing you want to do is “lock in” low interest rates. When the economy finally gets going again, corporate profits may rise, and with them, stock prices. But beware: inflation can easily crush stock prices, as described in the last paragraph. So our advice is: invest only very cautiously in stocks, and be ready to pull out of them if interest rates and inflation rise. In fact, it may be best to “get ahead of the curve” and invest in such inflation-busters as gold and inflation-protected bonds now, while they’re relatively cheap. The best time to invest in life insurance is when you’re young and healthy. The best time to invest in “inflation insurance” may well be at the time when people don’t feel they need it—in other words, right now.

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