The Deflation Fighters

Beneficiaries of Inflation

We are confident that the central banks of the world will be successful in their mission to avoid deflation, because how could they not be? How could institutions with unlimited power to create money, including the power to monetise every public and private sector debt in the land if they chose to do so, not be able to depreciate their currencies via inflation if they really set their collective minds to the task? The US Fed has certainly set its mind to the task. No doubt aware that the supply of money is more important than the cost of money, the Fed is working hand-in-glove with the private banks and the GSEs (Government Sponsored Enterprises) to rapidly expand the US money supply. This money supply expansion is inflation. One of the effects of this inflation will be higher prices somewhere within the economy (unless this turns out to be the first time in the history of the world that a large and sustained increase in the supply of money does not lead to higher prices). 

The investment landscape has undergone a change over the past 2 years and the major beneficiaries of the inflation of the late 1990s will not be the major beneficiaries of the inflation of 2001 and beyond. Of all the changes that have occurred we think the one with the greatest long-term significance is the downward reversal in the US Dollar's exchange rate. The US Dollar's rising trend over the past several years made dollar-denominated financial assets irresistible to investors outside the US and has helped suppress commodity prices in US$ terms. As long as the Dollar was strengthening there was little incentive to hoard commodities because it was perceived that commodity prices (in US Dollars) were not going to be any dearer in the future than they were in the present. With the US$ having probably embarked on at least an intermediate-term downtrend, we think the greatest effect of this current bout of inflation will be seen in the prices of commodities. 

Gold, due to its monetary quality, is usually the first commodity to respond to an inflation-induced rise in commodity prices (gold will sometimes respond 1-2 years in advance of such a trend change). So far this year we've seen good relative strength in the prices of gold and gold stocks, something that is consistent with our view that a bull market in commodities is likely during 2002 and 2003. If we are correct then it is still very early in the new cycle and gold should remain our major focus for now.

The Smoke Screen

As evidenced by the behaviour of short-term lease rates, central banks have practically been giving gold away to anyone who wished to borrow it over the past 2 weeks. This is most likely being done to create the illusion of financial market stability. Governments and their bankers are doing their best to distort our view of the fundamentals, but the fundamentals are what they are. A gold rally was stopped in its tracks in 1999, but the fundamental backdrop is now very different. 

In the short-term the price-fixers might be successful, particularly if the military operations in Afghanistan can achieve some initial success and thus give a temporary boost to confidence. Beyond the next couple of months they cannot be successful because central banks can create currency, but they can't determine how that currency is used. The 165 billion dollars that were added to the total US money supply during the week ended Sep-17 is sufficient to purchase about 13% of all the gold ever mined in the history of the world. The $900 billion dollars that have been added to the total US money supply over the past 12 months are enough to purchase about 75% of all the gold mined in the history of the world. If we also take into account the money created outside the US then enough new fiat currency has been manufactured over the past year to purchase all the gold ever mined. Unless central banks can either find a way to convince investors throughout the world to ignore the massive inflation that continues unabated or a way to create new physical gold as quickly as they can add 'ones' and 'zeros' to the memory banks of computers, they will be powerless to prevent a dramatic rise in the gold price. This doesn't mean that we should stubbornly cling to our gold stock holdings no matter what (our goal is to make money every year, not hold-out for one magnificent pay-day at some undefined point in the future), but we need to keep this big picture view in mind. The attempts of central banks to keep a lid on the gold price will inevitably be swamped as a result of their own profligate monetary policies.

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