The Inflation
Problem
Two weeks ago we published an article
titled "Gold and Deflation" in which we argued that the gold price would
fall during a period of genuine deflation (a period during which the total
supply of money and credit was shrinking). In response to this article
we received a lot of e-mails from people who argued that we were wrong,
that the gold price would rise during a period of deflation.
It is, of course, possible that we
are wrong. For example, if deflation caused people to become fearful that
the current monetary system was going to collapse then the demand for dollars
could fall at a faster rate than the supply of dollars. In such an environment
the demand for gold would soar and so would the gold price. This is, however,
something that would probably only happen after a prolonged period of deflation
(1-2 years). During the initial stage of deflation the demand for cash
would increase. In any case, that is the last we are going to say for a
while about how gold would perform during deflation because the US (and
the world) does not have a deflation problem, it has an inflation
problem. When the probability of deflation occurring within the next 12
months becomes significant we will deal with the subject again.
Note that having 'inflation' and having
an 'inflation problem' are two different things. The supply of US Dollars
has been inflated at a rapid rate during each of the past six years, but
the US has only had an inflation problem during the past two. The
fall in the US$, the rises in the prices of gold and gold shares, and most
recently the rise in the CRB Index, are all symptoms of inflation. They
are, in effect, the 'inflation problem'. For years the US had inflation
but did not have an inflation problem because the inflation fueled asset
prices while the US Dollar trended higher against the other fiat currencies
and against gold. It is only during the past 2 years that the inflation
has begun to manifest itself in ways that most mainstream economists would
not consider to be positive. That is, the inflation has begun to work against
the US financial and political establishment rather than work for them.
The large and chronic US trade deficit
is an effect of inflation, but the trade deficit wasn't a problem
until it could no longer be offset by a foreign investment surplus. When
the real returns being generated by dollar-denominated assets and debt
became less attractive to foreign investors, the trade deficit became important
and the dollar began to fall.
So, the US has an inflation problem
now, but what makes us think this problem is going to persist for at least
the next 12 months?
One reason is price action. Quite simply,
the rallies in gold, gold shares and the CRB Index look like they have
a long way to go, as does the decline in the US$.
Another reason is the delayed effect
of money-supply growth. Last year's surge in the money supply has not yet
been fully reflected in prices and the effects of this year's surge won't
be seen until at least next year.
A third reason is that falling employment
and major problems in some parts of the economy, such as the telecom and
banking sectors, will prevent the Fed from reacting to the 'bad' effects
of inflation in the normal way. For example, below is a chart showing the
ECRI's Future Inflation Gauge (in blue) and the Fed Funds Rate target set
by the Fed (in green). The Future Inflation Gauge (FIG), which should actually
be called the Future CPI Gauge since it is designed to predict changes
in the CPI not changes in the inflation rate, has been an exceptionally
good leading indicator of the Fed Funds Rate since 1987 (the year that
Greenspan became Fed chairman). There has been a very sharp upturn in the
FIG since early this year. In fact, the FIG is now quite close to the levels
reached just prior to the start of the Fed's rate-hiking programs in 1994
and 1999. And yet, the main topic of debate amongst 'Fed watchers' is whether
or not the Fed will cut interest rates at the next FOMC meeting.
The current economic problems and the perception (particularly amongst
those responsible for setting monetary policy) that deflation is an imminent
threat, will likely result in short-term interest rates being held at their
current low levels for too long. This, in turn, increases the probability
that the inflation problem will persist over the coming 12 months.
A fourth reason is that the recent
rally in the bond market all but guarantees strong money-supply growth
over the next few months. This is because, in the current US 'credit bubble
economy', rising bond prices are inflationary in that every substantial
fall in long-term interest rates precipitates another surge in the total
quantity of mortgage debt. The below chart illustrates this point. The
blue line on the chart shows an index designed to reflect the level of
mortgage financing/re-financing activity. The green arrows on the chart
have been drawn by us to show the direction of US Government bond prices.
US home owners/buyers, as a group, will eventually reach a point where
they will be unwilling or unable to take on more debt, but that point has
clearly not yet arrived. They have responded to the latest bond market
rally in the same way that they responded to every bond market rally over
the past 7 years - by borrowing more money.
Over the past 24 months, and particularly
over the past 12 months, inflation has become a problem in the US because
its effects have begun to show-up where they are not wanted. This creates
a quandary for the Fed because, with private-sector debt levels having
reached stratospheric heights and with this year's economic recovery on
shaky ground, the Fed must continue to promote inflation rather than attempt
to squash it. But, Greenspan and Co. have lost their ability to simultaneously
promote inflation and control its effects.
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