Anticipated Inflation in a Deflationary Environment

Several people expressed confusion over my gold article yesterday so I wanted to take this opportunity to elaborate.

Why is the short term gold outlook uncertain?

The actions recently taken by the Fed and the Treasury to pump trillions of dollars into the market is in the long run an inflationary move. I know that, you know that, everyone knows that. However, we can make a few observations that show the uncertainty in the short term.

Usually the market works to quickly discount news based on the probability that it ultimately becomes reality. Well these liquidity injections are already reality, yet gold is not trading above $1000 which is what would make sense in a regular environment. Why is this environment not regular? Because we are currently sitting in a deflationary trap. With all of this liquidity being injected, some Asian banks last night reportedly quoted rates on USD as high as 7%. That is NOT inflationary. Credit not being able to find its way into the market is NOT inflationary. But it will eventually get there…

So the question is: How does gold trade in a deflationary environment that will ultimately end in inflation? Does it start discounting inflation (rising prices) while all other assets, paper and real, are deflating? Another way to think about this is the housing market. Real estate usually appreciates like gold in an inflationary environment, yet the market is clearly deflating right now. Should housing prices start moving up in anticipation of future inflation? The markets' method of discounting the future is difficult to approximate, regardless of whether or not we have quality expectations of what will happen in the future.

Effects of Global Rate Cuts

After the RBA cut rates by more than expected last night, the global markets inflated including gold. This made me rethink my hypothesis on non-US intervention, as foreign money is likely to find its way to market faster than USD in this environment. Therefore I would say that the price of gold has shifted away from the US easy-money policy which is largely discounted and anticipated. The market is also discounting foreign action, but as we saw in the case of the RBA yesterday, doing more than the market expects will be inflationary in the short term. If this is the case, we may see gold and the USD strengthening alongside each other in the short term until the USD liquidity finds its way to market, at which point gold should take off.

Considering the Unspeakable

My final thought will likely be met with hostility. Let me say upfront that I am of the opinion that the Fed will be unable to time the removal of excess liquidity once the credit markets unfreeze. But what if I am wrong? As much as the gold bugs criticize the Fed about keeping rates too low, many economists criticized them for not cutting enough as the crisis was unfolding. What if the Fed does its job properly this time around? What if all of this excess liquidity is drained as the credit markets open up in an orderly fashion as Bernanke suggested in his speech today? How will a market anticipating very high inflation in the future react to that?

For the record I am not saying that it will happen - Bernanke has yet to prove himself in that capacity. I believe the odds are strongly against it and on a personal level I have never had too much confidence in central planning. Yet you cannot ignore the odds, as small as they are. What we do know is that this is their goal (conspiracies aside) and it's their legacy as well. While I may be betting against them, I hope they defy the odds.

Comments

[CaptBob:]

At times of crisis such as this no-one knows anything for sure--Except the ship is going down!.

If it doesn't, it will be the first time in history any ship has sustained this amount of economic damage and sailed on unscathed.

When you witness these numbers of Fibonacci Rats deserting you can only draw the general conclusion, "She's going down".

To try and predict what direction the rats --(unless you know where land is)--will swim or how long the process will take has the same odds of a blindfolded dart hitting the bulls eye.

Just put on your life jacket -(gold)-and leave it on. Don't worry whether the seas will be choppy or calm in the short term.

2008 Oct 08 11:11 AM

[whidbey:]

Mild deflation may not be such a problem on one country, but global deflation is a serious problem and there is no fix except to inflate the money supply;that is called pushing on a string. I suppose that public works are the ultimate answer, or a war. That is human history and likely our future. I am not unduly negative, but looking at where events are unfolding, in stead of waiting for statistics to be published is helpful.

2008 Oct 08 11:42 AM

[CLH:]

Deflation is caused by elimination of debt. There is no way there can be inflation when debt is removed. I will soon be shorting gold again.

People will NOT borrow which means there cant be inflation.

2008 Oct 08 02:25 PM

[Moon Kil Woong:]

More money is being destroyed than created but letting the fed inflate $ by extraordinary means means congress and budgets and the fed and the power to coin money is no longer in the government's hands. That is a terrible precedent no matter how you put it. In the end, only the debtless and those the fed pumped up with minted $ will be ok when they deflate their excess experiment in self inflating the money supply. Congress is obviously too stupid to notice and too incompetent to do anything about it.

2008 Oct 08 11:29 PM