Dear Fellow Investor, Extreme indebtedness at the federal level has a consequence that has flown under the radar: It places a thorny limit on the capacity of the Federal Reserve to raise interest rates, since servicing the debt would become nigh impossible. So long as inflation is low and there is political pressure for expansionary fiscal and monetary policy, this impediment to higher rates is a relative non-issue. The irrelevance, however, is changing rapidly. The predictable outcome of impotence from the Fed is a higher long-term rate of inflation in the United States. In January of this year, the Consumer Price Index spiked 0.5 percent, higher than expected. It is equivalent to about 8 percent on an annual basis and far in excess of the 2 percent stated target. The energy component alone rose by 3.0 percent in a single month.



Market participants have taken this as a sign that multiple hikes to the Federal Funds Rate are on the way. However, as Editor Brien Lundin has noted in previous Golden Opportunities releases, both Janet Yellen and Fed presidents have referred to a rate of 2.5 percent as a "new normal."



If we take that as a de facto ceiling, it is just 1 percent higher than the prevailing 1.5 percent (four rate hikes). Both the ceiling and the present rate are remarkably low historically, and the 2.5 percent rate will have little capacity to rein in inflationary pressure.



That begs the question: What's the problem with higher inflation? That may seem like a no-brainer to many readers. However, the younger generation, who grew up in the 1990s and 2000s, has little experience with inflation beyond a few percent.



First, let's identify the impacts. Then we can do something about them.



As Warren Buffet wrote way back in 1977, "inflation is a far more devastating tax than anything that has been enacted by legislatures. [It] has a fantastic ability to simply consume capital."



This tax is particularly pernicious because it is so invisible to the naked eye, as it erodes fixed incomes, bond returns, and all cash and dollar-denominated holdings. Even dividends, assuming a degree of stickiness, take a hit in the face of inflation. Beyond eroded returns, shoe-leather and menu costs leave less available to offset depreciation and finance the underlying capital formation necessary for real productivity growth.



In other words, if inflation climbs north of 3 percent, while the Federal Funds Rate is capped at 2.5 percent, we will be stuck with negative real interest rates. One could make a strong case that we have already arrived, given legitimate concerns about how the Bureau of Labor Statistics measures and likely understates inflation.



Behavioral economics indicate that humans tend to have egos beyond their merits, which leads to overconfidence and over-optimism. There is a temptation to think you know just the right stocks to buffer against the costs of inflation, to stay ahead of the pack.



The Oracle of Omaha also has a gem on this tendency, since in aggregate such an outcome is impossible, and the increased trading only costs participants: "I would like to be your broker-but not your partner."



The most appropriate response is to look beyond the conventional domain of stocks and bonds, and to seek asset protection. Negative real rates, for example, are extremely bullish for precious metals, which act as a safe haven from the dollar and other currencies, which in Europe are suffering from the same predicament.



Our latest episode of the Gold Newsletter Podcast was, in fact, on alternative investments. The guest, Donald Chambers of CAIA, advocated three broad categories for portfolio diversification: real estate, private equity and real assets. "Instead of buying something like Google…that has almost no tangible equipment and buildings. It's almost all intellectual property," Chambers explains. "Real assets [are] the other end of the spectrum." The best opportunities in this domain, he claims, are in master limited partnerships. One way to get exposure to these, in a less taxable manner, is via exchange-traded notes such as the Alerian MLP Index ETN. These diversify holders into oil and gas, although he recommends the ETNs rather than any specific MLPs.



That is his educated opinion on what to do when facing very low or negative real interest rates, alongside high price-to-earnings ratios. And again, gold and silver are classic inflation hedges, especially at a time like today when the entire financial system seems unsustainable.



However, the most important insight from the latest inflation and debt numbers is that we face more of both, so either find protection or expect to get a haircut. Fergus Hodgson is an economic consultant and Gold Newsletter’s roving editor.