As investors feverishly debate the prospects of deflation vs. inflation, the market is not providing us with a clear answer as yields on Treasuries plummet (deflationary signal) and gold soars (inflationary signal). While we recognize the merits of the deflation thesis including: deleveraging of over levered balance sheets, high unemployment, and a weak housing market, we are more concerned with the threat of inflation and reduced purchasing power.
Chairmen Bernanke has stated,
By increasing the number of dollars in circulation… Under a paper-money system, a determined government can always generate higher spending and hence positive inflation.
We believe the mantra of "Don’t fight the Fed” is appropriate here. Under a paper-money system the Fed theoretically has a gun with unlimited bullets.
Many deflationists point to the lost decade of Japan as a case study for the U.S. We believe there are flaws in those statements. Having studied the Great Depression and the Japanese situation, we believe Bernanke will be more aggressive against the threat of deflation. While high unemployment has real, current day implications, the loss of purchasing power is more opaque. The chart below outlines the cumulative monetary expansion since the housing bust. As shown below, the Fed has been significantly more accommodative.
Debts are borrowed in the dollars of yesteryear and repaid in dollars of today. If the Fed can engineer 3%-5% inflation on top of 2% growth, the Fed can devalue the debts of yesteryear by 5%-7% per annum. After five years, the debt burden is reduced by 25%-35%. Our concern is that forecasts are often wrong and there will be unintended consequences with created “nominal” levels of inflation.
We ask investors the simple question: What will hurt you more...inflation or deflation? As savers and investors, we believe the loss of purchasing power is more of a concern as inflation can get out of control quickly. Deflation slows down activity, while the fear of inflation speeds it up. History has shown that inflation can get out of control quickly.
We own gold and silver in physical and ETF form (GLD and SLV). We follow a policy of not timing the market but slowly accumulating these metals as they are our insurance policy against inflation. Investors interested in vehicles that retain physical metal should look into Sprott Asset Management’s Sprott Physical Gold Trust (PHYS) and Sprott Physical Silver Trust (PSLV).