Debt As An Inflation Hedge

I highly recommend Axel Merk’s latest discussion of the Fed’s fight against deflation. He addresses many of the currency and debt dynamics I have touched upon here in the past weeks, but with greater technical depth and detail. One element of Merk’s discussion deserves particular focus:

Banks are in the business of borrowing short and lending long: typically, banks would have deposits (short-term loans from depositors, callable at any time) and lend to finance long-term projects. This may well be the greatest carry trade of all times, except that it has neither credit, nor currency risk; it does have interest risk, i.e. if long-term interest rates go up because the market prices in the risk of inflation, then banks could lose money.

A bank pays a lower rate of interest to its depositors than it charges for the long-term loans it lends. If it gives its depositors 2%, but charges its debtors 6% for a mortgage, it profits from the 4% spread.

The risk to the bank from rising interest rates deserves our attention because, as Merk explains in his article, it now drives a number of the Fed’s current actions. I have already alluded to the possibility that China may grow increasingly reluctant to purchase US debt obligations. The drop in oil prices now makes it less likely that oil producing countries will want to purchase US debt, as well. By the simple law of supply and demand, a decrease in demand for US Treasury Bonds would force interest rates to go up.

Now imagine a scenario in which rising interest rates force the banks to pay its depositors 4%. The higher payment to the depositors squeezes its spread on the mortgage loan down to 2%. Many banks mitigate this kind of risk by selling mortgages to third parties. But of course that just transfers the problem to bigger banks.

As the bank of all banks, the Fed must do everything to protect the interests of the banking industry. Thus, as Merk observes, on November 25 the Fed announced that it would purchase $600 billion of mortgage-backed securities. This announcement signaled to the market an increase in demand for these securities and consequently sent their yields lower. The Fed publically justifies these actions as a means of unfreezing the credit markets. But they also have the effect of protecting the banks’ profits. The Fed has many other tricks up its sleeves to accomplish these goals, all euphemistically defined as Quantitative Easing.

The debate rages between the deflationistas, such as Mish Shedlock and Robert Precther, and inflationistas such as James Turk and Peter Schiff. The question boils down to one’s belief in the the Fed’s ability to accomplish its goal of getting money to move through the economy to prevent a deflationary spiral (a state of high unemployment and consequent decrease in prices as the country suffered in the Great Depression). If it succeeds, but fails to remove the excess money it created from the system, inlation will result.

As a believer in both the Fed’s ingenuity and the inevitability of inflation, I have suggested investing a limited but steady stream of savings in precious metals, for reasons that I have outlined in this blog. But, in the interest of diversification, I am now scrutinizing another tool for coping with inflation: a fixed rate mortgage.

If you have the nerve to tolerate the gory details of how badly our government manipulates inflation statistics, I recommend having a look at John Williams’ Shaddow Stats. Using the same inflation calculation methodology that the government used in the 1970s (when it counted food and energy in its inflation formula), Willams estimates current inflation to be at around 11%. But because the government’s official inflation numbers understate inflation by about 7%, salaries have not kept pace. The 1970’s differed insofar as the government did not lie about inflation so that salaries did increase with inflation.

Daniel Amerman makes an important observation about all this: people who held fixed rate mortgages from the 1960s paid those mortgages off in inflated dollars throughout the 1970s and got their homes virtually for free. The fixed interest rate guaranteed that the payment in nominal dollar terms stayed the same, while salaries, again in nominal dollar terms, increased. This dynamic made the mortgage payments an increasingly smaller expense of household budgets. In effect, inflation transferred wealth from creditors to debtors.

Now it should be even more clear why, as I discussed above, the Fed will do anything in its power to prevent interest rates from rising.

No one can know for sure whether or not the Fed will succeed in preventing a deflationary spiral, or whether inflation will become undeniable enough that salaries have to rise. But Amerman would argue that even people who can afford to own their homes outright can benefit from mortgaging some percentage of their home as a hedge against inflation.

In order for this strategy to work, a number of conditions must be met:

  • The homeowner must have emergency cash available for making the mortgage payments for any foreseeable period of unemployment;
  • The homeowner must also have diversified their portfolio into assets that would do well if inflation does not turn out as predicted;
  • The mortgage’s interest rate must be fixed; an adjustable rate mortgage in a period of inflation is disadvantageous to the mortgage consumer.

To be honest, I am not sure whether I believe this strategy to be practical or ethical. But it intrigues me. If nothing else, this discussion will have given you a better understanding of how the banking system works and how it could even work to your advantage.

DISCLAIMER: I am not a professional financial planner and have no credentials in this area. You should always review your financial plan with a qualified financial planner. I recommend finding one who understands monetary inflation and peak oil.

© 2008 Philip Glaser

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5 Responses to “Debt As An Inflation Hedge”

  1. Jeff G Says:

    Interesting idea. But the question that remains for me is, what to do with the cash from the mortgage? Put it in the bank? Buy gold and silver? Treasuries? All of the above have risks and are subject to manipulation by power players.

    In the mean time, you have put your core asset at risk, so in a major downturn you might lose your lifeboat.

    Perhaps the strategy makes more sense if you have the resources to invest in additional real estate, but I would still worry about having to make payments and taxes on property that perhaps won’t return enough income to cover it, nor retain enough value to sell it profitably.

    Basically, I think I am chicken–with the end result of probably watching my cash-held assets disappear slowly to inflation. No easy choices…

    • Philip Glaser Says:

      Hi Jeff,

      I agree that there are no easy choices. And that market manipulation really makes it hard to anticipate how to mitigate risk. At this point I am thinking about the fixed-rate mortgage as a piece of the puzzle. I do think that broad diversification across cash, commodities, and some types of equities provides some measure of protection. Anyone who gets rich investing over the next ten years will do so because of dumb luck and not because they could predict trends or even follow any existing trend. The best one can hope for is to hang on to some meaningful piece of their savings, which I fear may be a much better outcome than most people will be able to hope for.

      Thanks for commenting.

  2. Inflation Versus Deflation: Part Two « From The Tower Says:

    […] any government facing this level of debt obligation. You’ll recall from my discussion of the mortgage as a hedge against inflation that inflation transfers wealth from creditors to debtors because the nominal value of the loan […]

  3. Bill Cash Says:

    Interesting ideas. There are definitely no easy choices…

  4. Bill Cash Says:

    I just stopped by your blog and thought I would say hello. I like your site design. Looking forward to reading more down the road.

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