This week saw a fundamental shift in Paulson's approach to restoring the proper functioning of the credit markets. I have been arguing for some time that the credit being pumped into the market is not finding its way into the system. The way that this plays out has direct implications for the price of gold.
As you can see in the chart above, there was a swift shift in the momentum for gold mid week. What happened was that gold was in a solid downtrend because real rates were seen as being high and the Fed is running out of ammo to lower rates. Then Paulson made his announcement, admitting that the recapitalization of banks is not leading them to lend to consumers. He announced that he was shifting his focus to getting credit to consumers.
Following that, gold tried to test $700 as it WAS in a downtrend. However, that shift in policy is inflationary. As I have been arguing, should rate cuts and public credit find its way out to the private market, inflation will hit hard, and seeing as it is unexpected by the market, it would likely be violent. This led to a sharp adjustment upward in price.
This once again brings us to the question of credit finding its way into the market. And although the rhetoric from Paulson is inflationary, the question still remains whether or not the Treasury will be able to get private institutions to lend to individuals. In my opinion this could only be done by nationalizing the banks out right thus giving the government power to control the banks lending practices - very unlikely. Therefore I conclude that deflation remains more of a concern than inflation for the time being.
Inflation/Deflation
The best analogy I have of inflation and deflation is the weather - inflation being a hot day and deflation being a cool one. In general, our credit based economy prefers a little credit growth in the long run, just how most prefer warmer days to cooler ones. Then comes along a really hot day (lots of inflation), but you can always sit in the shade or jump in the swimming pool (raise interest rates Volcker style) to cool off. There are some that REALLY hate the heat (Austrian School of Economics) and even in the middle of winter dread even slightly warmer days.
But as bad as the heat is, the cold is worse. You can start a fire or put on a sweater to warm up, but failing to do so could be very bad for your health - possibly fatal. Extreme heat is uncomfortable while extreme cold is potentially deadly.
As bad as inflation is, deflation is worse as there's only so much medicine that you can take. Once rates reach zero and growth moves into negative territory, real rates are high, and there's nothing that can be done about it. This has a very negative feedback loop as cash gets more valuable by the day. Every cent saved today is worth more tomorrow, which kills real asset prices, deters consumers, and investors. You need to look no further than Japanese real estate to see the ugly face of deflation. The worst part about it is that existing debt becomes more of a burden with each passing day, as the money you borrowed and used is worth more and more in real terms and paying it back becomes an impossible task.
It is for this reason that the world's leaders are focusing on deflation rather than inflation. Some inflation may very well be the consequence of these actions - but the alternative is far more destructive. Then there is still the possibility that the Fed is able to drain the excess liquidity before inflation strikes, although that would be a very impressive feat.
Disclosure: Author owns OTM calls, trading with bear bias
