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Gold peaked at just over 1900 dollars an ounce about a year-and-a-half ago and has been falling ever since. As of this writing gold hasn't broken to new lows, but it may. The question is "why?" There are many reasons, but the first and foremost reason is due to an incorrect monetary assessment by most gold bugs and their followers. Over the last many years, the gold community was divided into two camps: those who believed we were going to endure an inflationary depression, and those who believed we were in for a deflationary depression. During this great debate many first-time gold investors were attracted to both arguments and entered the market.

However, it has become clear, especially over the last couple of years, that we are not experiencing an inflationary world, or a deflationary world, and that a new great depression is not imminent. Slowly gold bulls lost patience as did their followers. They began to reduce their holdings of gold stocks, then gold itself. It's been over four years since the Fed substantially increased the money supply. Most were sure that inflation was imminent. After a year, the inflation camp extended its timeline to a couple of years. Surely, we would have massive inflation by then. (Monetarists held that any new money printed by the fed would show up as inflation within nine to 18 months.)

As commodities rose, then fell from their highs, inflation turned to deflation. The Fed increased the money supply in response, which was dubbed QE2. And again the inflation hawks extended their timeline. Gold and gold stocks rallied, but only briefly. Then they resumed their fall once again.

Then came QE3. QE3 led to a similar inflationary-induced bounce, but this time even more briefly and was sold quickly. Since then we have continued to fall to near previous lows as no real inflation materialized; and this after four years of unprecedented money creation. Even the inflation bulls have had to admit that there is no theory that states that inflation will soar after four years of increasing the money supply. If it hasn't happened under the extreme monetary expansion of the last four years, when exactly will it happen? For a complete discussion of the reason why progressive inflation never occurred, read: "Why Prices Are Not Skyrocketing" - at paulnathan.biz, written in 2010.

The deflation hawks were equally wrong, but closer to the mark as they understood that the real threat was de-leveraging, which caused a credit crisis, a deflationary depression in housing, and a continuous weight on the economy institutionalizing slower growth. However, they took their theory to an extreme and extrapolated the theory to the point of predicting total collapse. The deflationary depression never occurred.

I rejected both theories at the time and postulated in 2008 instead, that we were in for a new era: a world of L, as I called it, where we would endure flat growth and high unemployment for years to come. My annual "Looking Forward" articles can be found on my site paulnathan.biz under commentaries. This indeed has been the world that developed and continues to plague us to this day.

Where do we go from here?

Today the conversation has turned from will the Fed cause hyper-inflation, to will the Fed stop easing monetary growth soon and bring on recession? Once again, I suggest that the pundits of today do not understand the Fed. The Fed has no intention of creating a recession by tightening monetary policy. It is charged primarily with preserving price stability. This is something the Fed has done and can continue to do. We learned the lessons of the great depression when the Fed tightened monetary policy in the thirties and induced a deflationary depression. It will not make that mistake again.

And we also learned the lessons of the '60s and '70s when it ignored the inflation rate and watched inflation go from 2% to 14% rates and created a monetary crisis that led to 20% interest rates and nearly crashed the dollar and destroyed the economy. It will not attempt that again either.

The Fed cannot control economic growth, it cannot lower unemployment, and it cannot stimulate the economy. Look to the last four years as proof of this. What it can do, however, and has done is prevent deflation and inflation. It can foster price stability and again the proof of that is in the movement of prices over the last four years.

Inflation during that time moved up toward 4% rates, and down toward actual deflation rates. What didn't happen is progressive inflation or deflation. Inflation was contained within a narrow range moving both up and down no matter which measure you use. Today, gold is signaling that we are moving toward the return of a recessionary/deflationary bias in the system. We see it in the GDP, which has fallen from 2.5% rates to flat, and in the commodity indices which are breaking down. Gold has led that fall as it usually does.

While all the talk is how and when the Fed will tighten, I am sure that in a very short time the conversation will turn to how and when the Fed will ease to prevent a recessionary deflation from taking hold. Once again, the inflation hawks will scream inflation! But in fact all that will be happening is the Fed doing its job to prevent deflation.

If anything, the increase in the money supply has been anti-deflationary, not inflationary. Japan has finally learned this after 30 years of a deflationary monetary policy and recession. It has begun to fight deflation by increasing the money supply. Many pundits and even governments have expressed alarm over its intention to print money hand over fist and fear a currency war. Such concerns are unwarranted. Although it is true that the yen will fall, it is because it has been supported by an abnormal deflationary monetary policy. As soon as it adjusts to the new amount of money in circulation and finds its true market value, the yen should stabilize. Just as the dollar has remained stable and inflation contained, so it will be with the yen. (The U.S. dollar index was 80 in 2010 and is 80 today in spite of all the talk of it crashing and burning.)

And then there is Europe. It snubbed Bernanke when he went there to voice his strong suggestion that it set up a system more like the Federal Reserve System with a central bank that has the ability to fight deflation and bank runs. He was sent home unwelcome and the media crucified him for his suggestion. It is now in the process of doing just that. And have you noticed that the financial panic immediately ended with the mere announcement of its intention to do so.

The end of financial panic in the eurozone is as good a reason as any for gold to fall. It is becoming clear that we are not headed for runaway inflation nor insolvency, but that deflation and recession is our continued nemesis as this country and many others de-leverage from a decade of over leverage. Central banks can prevent deflation and inflation as well as cause it. This is something that Milton Friedman taught us long ago.

As a result of learning this, many individuals and investors will reduce their safety holdings such as cash, gold, silver, and bonds as fears fade. This is not to say that we are out of the woods, but fears have lessened and hedge funds are already in the process of reducing their holdings of gold, and investment demand for gold has dropped around the world in the last year.

Now add to this the fear of the implementation of the sequester, which may be on going, higher gas prices, and higher taxes and fees this year, and why should gold not fall? Austerity isn't just around the corner. It's here. The stock market and bond market may be next to recognize what the gold market has been telling us for some time. We are in for a tough period ahead. Watch the money supply, the velocity of money, the direction of commodities, the direction of interest rates, and especially gold. These will be the tell-tale signs of our economic and monetary future.

Source: Why The Price Of Gold Is Falling