Inflation
and the Race to the Bottom
Gold, Inflation and Deflation
We do not think that gold would
prove to be a good investment if the US experienced a prolonged period
of deflation (a prolonged period when the money supply is contracting).
During a true deflation cash is king and asset values fall relative
to cash. Since gold does not circulate as currency its price would fall
along with the prices of all other assets. Gold's monetary qualities and
its worldwide acceptance as a store of value should result in the price
of gold holding up better than the prices of other assets, but as an investment
it would under-perform cash US Dollars and US Government debt.
We may or may not be right regarding
gold's relative performance during a period of deflation, but it really
wonít matter for at least the next year and for probably much longer than
that. Based on what we have seen over the past few years and what we continue
to see almost every week, the probability of the US experiencing deflation
at any stage over the next 12 months is infinitesimal. Recent events have
shown us once again that the US Federal Reserve follows a policy that can
be loosely translated as "when in doubt, inflate".
Deflationists keep telling us that
the Fed is powerless to stop the deflation and usually cite the example
of Japan to support their case. They are, however, ignoring the evidence
of their own eyes. Within one year of the Japanese stock market bubble
bursting Japan's year-over-year M2 growth rate had plunged from 12% to
2% and the BOJ really did seem powerless to do anything except cut interest
rates. At the US stock market's bubble peak the year-over-year M2 growth
rate was 6.3%. In early-September this year it was 9.3% and then, in the
space of one week without hardly scratching the surface of their money-creating
powers, the Fed was able to elevate the year-over-year M2 growth rate to
12.4%. It is crystal clear that perceived threats to the US financial system
are being met with ever-increasing doses of inflation.
At the moment the inflation is in the
pipeline, but the future effects of the inflation are only apparent
to those who can, and want to, see. With the economic news being generally
quite lousy and likely to get even worse as a result of the terrorist attacks,
with the effects of the inflation not being evident in any of the popular
price indices and unlikely to become evident over the next few months,
and with the drop in energy prices likely to further suppress the obvious
signs of inflation in the near-term, there will be no pressure on the Fed
to deviate from their inflation policy. In actual fact, there will probably
be a lot of pressure on the Fed to step even more firmly on the monetary
gas pedal.
Major policy changes only ever happen
when circumstances force them to happen. As such, inflation will
continue to be not only the preferred option, but the overriding goal,
of US monetary policy until the effects of the inflation become so painful
that a policy change is deemed necessary. The time to start thinking seriously
about deflation will be after inflation has caused interest
rates, the gold price and the popular price indices to move much higher.
The race is on
The Yen has been one of the weakest
currencies over the past 12 months, yet following a rebound of only about
5% from its lows Japanese monetary officials began to complain that the
Yen was becoming too strong. Over the past 2 weeks, with the Yen
having rallied about 7% from its lows (against the Dollar) but still being
9% below where it was at this time last year, the Bank of Japan sold Yen
in an attempt to weaken it against both the Dollar and the euro. It is
clear that the Japanese authorities do not want the Yen to be a
strong currency.
When the euro was introduced at the
beginning of 1999 it was worth US$1.17 on the foreign exchange market.
It then fell in almost a straight line for about 22 months, eventually
hitting a low of $0.82 in October of 2000. However, it wasn't until the
final stages of the euro's decline that European monetary officials began
to express some concern regarding their currency's relentless slide. In
fact, until the euro plunged well below $0.90 it almost seemed as though
European officialdom were cheering every time the euro ticked lower against
the Dollar.
A point was finally reached, probably
as a result of the surge in the euro price of oil, when the perceived benefits
of a declining currency (greater revenue from exports) were seen to be
outweighed by the problems caused by a declining currency. There was no
doubt also a realisation that confidence in the new currency needed a boost
in the lead-up to the introduction of euro notes and coins at the beginning
of 2002. The ECB's approach to the euro's exchange rate thus shifted during
the second half of last year from benign neglect to support.
We expect that the ECB will do its
best to support the euro until the replacement of the individual national
currencies is complete early next year, at which point the desire for increased
export competitiveness may prompt a return to the original (unstated) 'weak
euro' policy.
The US has unofficially abandoned its
strong Dollar policy, partly through choice and partly because such a policy
is clearly unsustainable in light of the weakening US economy and the large
current account deficit. The US$ has been trending lower since early-July
and is expected (by us) to drop much further as foreign-based speculators
in the US financial markets head for the exits.
The Dollar's trend is down, but based
on past experience we can expect the central banks of the world to fight
this trend in order to make their countries' exports more competitive.
In some cases this trend-fighting will be done blatantly via intervention
in the foreign exchange markets (as per the BOJ's recent actions), but
mostly it will be done through interest rate reductions and money supply
additions. With the US Fed having been forced to drop any pretense of inflation-fighting,
the central banks of other countries will need to really outdo themselves
if they want to stop their currencies from appreciating against the Dollar.
Now that the Dollar has joined the race to the bottom there is nothing
in the fiat currency world that remotely resembles a store of value.
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