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.

Steve Saville

Hong Kong

September 23, 2002

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