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Larry Kudlow, after telling viewers during his Wednesday night Kudlow Reports that he is concerned about a stronger dollar and falling gold, asked (to his credit) the definitive question, "Is this a whiff of deflation?" He should be concerned. For several months now, while Kudlow and many others have been busy arguing that Bernanke and the Fed have been causing a lower dollar and higher inflation, the demand for dollars around the world has actually been growing so strong that money is becoming tight and commodity prices are dropping. All led by falling gold.

Despite a strong U.S. GDP in the fourth quarter, gold has been falling since last summer. In my recent article, The Return of the Recession /Disinflation Bias, I argue that falling commodities and resource stocks have been indicating for months that world growth is slowing and that disinflation is taking hold. The world is now moving quickly toward recession and if not combated, possible deflation.

And in an actual free market economy that is exactly where we'd end up, in a sharp deflation and recession, if not depression. That would be the natural correction after too much leverage and the accumulation of too much debt. But the world we live in will not permit such a correction as we choose to take a different road, i.e., increasing the money supply to meet the ever increasing demand for dollars. And lest some forget, that is exactly what a central bank is supposed to do under a fiat system.

This process has become known to the general public as "QE," or quantitative easing. But it is just the plain and simple monetary policy of a fiat standard under which the Fed's job is to prevent both inflation and deflation. The Fed must constantly determine whether the price index is stable. When it becomes obvious that either inflation or deflation is taking hold and is becoming progressive, the Fed must make its move. That's why I titled my previous article A Return to the Recessionary /Disinflationary Bias and not a return to a depression/disinflation bias. Ben Bernanke will do everything in his power not to allow this to turn into a deflationary depression.

While the Fed cannot prevent recession or even depression, they can prevent deflation - and have. The success comes at a price of course, but the judgment of our society at this time is that the price is not as high as a progressive deflation. So it's tolerated by most while tagged as "inflationary" by others, but the fact is that the Fed's policy is anti-deflationary. It must be, by mandate.

One interesting challenge for the Fed is that just looking at the money supply itself tells them nothing about whether money is too easy or too tight. For instance, money is pouring into our banking system for protection as individuals and institutions the world over cash in assets, buy dollars and deposit them in FDIC insured U.S. banks. And this bulge in the money supply has many alarmed and crying out that inflation is at hand.

But that simply isn't the case. Money is seeking safety, not chasing goods. The Fed need only look to commodity prices, headed by gold, to see this. Both commodities and gold are signaling a recessionary/disinflationary bias throughout the world. Leading indicators like Freeport-McMoRan (FCX) and Teck Resources Limited (TCK) are two examples of this. Gold has fallen to recent lows but gold stocks have fallen even faster and farther. Look at Goldcorp (GG) and Barrick Gold (ABX), let alone juniors such as Aurizon Mines (AZK) and McEwen Mining (MUX). As companies, these stocks are in fine shape, yet they have been sold off, many 40 to 60%. In fact most mines are highly profitable, cash rich and debt free. Yet their stock fell to 52 week lows, why?

Because the money supply is too tight, and if not eased, we are headed for recession, deflation, or worse. That's what the drop in commodities and gold and resource stocks in general are trying to tell us. Once the Fed grasps this they will move. And when they do, everyone will scream, "QE3! Inflation! Inflation!" But the Fed will just once again be following standard operating procedure and doing its job by preventing deflation from taking control. Panic selling of resource stocks, at levels unseen since Lehman and the crash of 2008, should be indication enough for the Fed and the Treasury that a change of course is now due.

Source: Why The Panic In Resource Stocks?