Inflation is and has been the monetary policy of choice since the gold standard was fully abolished in 1971; a long-term money supply chart shows a clear trend upwards with no real retraces. Traders and investors should ask themselves: what are the consequences of inflation being institutionalized as monetary policy?
1. It leads to a “pass the bubble” economy. When the Federal Reserve inflates to counter deflation, the excess money supply will be directed into an asset class besides the ones being deflated, thus leading to a new bubble. The bubble in US Treasury bonds is the current example of this.
2. A fiscal economy, not a production-based economy. The creation of money and the financial markets, rather than market needs, guide investment and production.
3. As the fiscal economy — the financial institutions that profit from the creation of bubbles — becomes the dominant part of an economy, the largest incentives are in speculation and enabling speculation.
4. It’s a trader’s not an investor’s, paradise. A “pass the bubble” economy is, in many ways, a short-term trader’s dream come true. When an economy becomes more driven by monetary policy than by market demand, speculation becomes more profitable than production.
5. Consistent with the notion that institutionalized inflation favors traders, analytical tools like technical analysis and short-term money management practices become an increasingly important tool in forecasting price movement.
6. Because legislation and brokerage firms can steer the Federal Reserve’s inflation into certain asset classes, sector trading — trading based on the correlation between sectors — may become more lucrative. The proliferation of ETFs facilitates this.
Other Key Considerations
It’s worth noting that bubbles can last for quite a while. In fact, there are those who argue there is currently a bubble in Treasury bonds, and that it will last a while — thus creating a prolonged deflation in the economy. As always we can look for momentum in price charts and potential outlier, “black swan” events to understand when the bubble is being deflated and how monetary policy will try to reflate.