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Deflation/Inflation
As
global growth is being downgraded by the I.M.F. from 3.5% to 3.1% fears that
the Eurozone is already in a recession and the U.S. is likely to enter one
next year, are growing. As the world becomes more and more familiar with the
economic and financial climate investors are realizing that economic life is
far from simple and that growth is not something that governments or central
banks can turn on or off.
Likewise
for all the clever construction of inflation and deflation measurements, the
public in general are beginning to realize that overall inflation and
deflation are far too simplistic to be given more than a ‘seasonal
influence’. The reality is that you can have both at the same time.
The reality is also that there are times when deflationary paths, in some
sectors, join with inflationary paths in others, to cause economic damage
that is caused by both being destructive [and not ruling each other out in
the addition of a minus to a plus -e.g. inflation at 2% with deflation at 2%
does not make zero - but the two combined have a damaging effect of 4%].
That’s what is soon to happen.
Inflation
in the U.S. is running at 2.4% per annum [ahead of the food inflation that is
on its way from the drought]. Deflation in asset values in housing is slowing
but the slowing of the velocity of money alongside the falling value of fixed
interest securities and a slowing economy, join together to undermine growth,
the future and confidence. With a desperate need for increasing economic
growth to stave off the destructive impact of inflation plus deflation, the
failure to produce economic resuscitation seems more likely, by the day, to
point to a new downturn. Then a very different type of inflation to food
inflation will come to be.
It
is excessive monetary inflation, which as we have seen does little to kick
start growth. It simply postpones recession. Subsequently, the deflation that
happens to asset values reaches down to the value of the buck in your pocket.
That’s when inflation really takes off to attempt to compensate for
growing deflation.
Where We Are Now
Where are we in this process now? We are
still at the start of a serious downturn as the Fed’s monetary stance,
while very positive, has failed to add real growth to the U.S. Chairman
Bernanke said the following last week, “Progress in reducing unemployment is likely to be
“frustratingly slow” and repeated the Fed is ready to take
further action to boost the recovery, while refraining from discussing
specific steps.
“The U.S. economy has continued to recover, but economic
activity appears to have decelerated somewhat during the first half of this
year,” Bernanke said to the Senate
Banking Committee in Washington. The Fed is “prepared to take further action as appropriate to promote a stronger
economic recovery,” he said. Bernanke said growth is slowing as
business investment cools in response to the European crisis [which is now
worsening] and the prospect of fiscal tightening in the U.S. At the same
time, households are restraining spending as unemployment remains elevated
and credit is hard to get.
The
Danger he is now facing in adding more quantitative easing is that he will
add more newly created money, without producing the desired effects of
raising employment. The net effect will then be to cheapen the value of money
itself.
The so-called ‘fiscal cliff’
would push the economy into a “shallow recession” early next
year, Bernanke said. [Unless Congress acts, $600 billion in tax increases and
spending cuts are set to take effect automatically at the start of next
year.] Additional negative effects would result from public uncertainty about
spending plans, including the debt ceiling. The most effective way that the
Congress could help to support the economy right now would be to work to
address the nation’s fiscal challenges in a way that takes into account
both the need for long-run sustainability and the fragility of the recovery.
The Fed chairman said Europe’s
financial markets and economy “remain under significant stress,”
and that’s creating “spillover effects” in the rest of the
world including the U.S.
That
said, European developments that resulted in a significant disruption in
global financial markets would inevitably pose significant challenges for the
U.S. financial system and U.S. economy,” he said. It is against this
backdrop that we now look at the way forward for gold and silver in the days
to come.
Gold & Silver in Deflation
The
definition of ‘deflation’ is:
While inflation erodes the value of
money, which progressively buys less and less per unit, deflation makes money
worth more. That makes people and businesses less likely to spend it -
consumers because they expect even better deals if they wait, and businesses
because it's less profitable to produce goods or services that will bring a
lower real return. These factors can feed on each other to produce a downward
economic spiral, as happened in the Great Depression.
To
us this is over simplistic as it describes only one picture of deflation. In
a global economy, the definition needs to account for the value of each
currency area suffering deflation. After all the balance of payments comes
into play and in turn the international value of the currencies suffering
from the aberrations of deflation and inflation.
As
brought out in her recent article, Rhona O’
Connell pointed out that in “The Golden Constant", written by Roy Jastram over 30 years ago and recently re-released
including fresh material by economist Jill Leyland, tells us that in the U.S.
there have been three recorded deflationary periods and gold increased its
purchasing power in each of them, by between 44% (1929-1933) and 100%
(1814-1830).
Please
note that this was at a time when the gold price was fixed and unable to
rise. Nevertheless, the purchasing power of currencies fell against gold. We
learn from this that while governmental controls do work, they work only up
to a point then are overwhelmed by market forces.
The
forces at work in the financial world now are pointing towards a coming
increasingly deflationary picture. If it does take hold then the deflation of
cash will overwhelm any quantitative easing the Fed may produce. If the Fed
were then foolish enough to print at a pace that keeps up with accelerating
deflation, then, it will simply create a hyperinflationary environment. But
will they have a choice. The same environment will happen in many countries
in the developed world but at different times and at a different pace.
The World Gold Council did some useful
work on this through Oxford Economics who found that gold is useful to
investors in various economic scenarios, not only during high inflation
periods. The research found that while deflation leads to a rise in the US
dollar it maintained that the destructive impact of deflation on traditional
assets was likely to outweigh the US dollar effect and provide a boost to
gold.
In fact, the analysis showed that gold
would outperform equities and housing in a deflationary scenario.
Additionally, a disinflationary (and
ultimately deflationary) environment provides central banks with more room to
manoeuver on stimulus. For example, on 5 July, the Bank of England,
People’s Bank of China and the E.C.B. acted in unison by announcing
accommodative measures in response to weak economic figures. These
accommodative measures should fuel the risk of consumer price inflation
further down the line while providing a temporary boost both to asset prices
and capital flows to emerging markets. It is our belief that if these
measures again fail [as they have done to date] central banks will be forced
by their political masters [despite their assumed independence] to print more
stimuli. This is how deflation will force inflation at an accelerating pace
onto the scene.
Further, the apparent dependency on
central bank support for an ailing global economy highlights its chronic
weakness. The combined weight of uncertainty and hope of central bank action
will maintain higher asset price volatility but faces the danger of
triggering runaway inflation in the back of rising deflationary pressures.
Right now, inflationary pressures may be
receding in various regions, but there are underlying trends to suggest that
deflation risk has increased. This challenging environment tends to be
conducive to gold investment.
New Banking Demand for
Gold
Temptation beckons central bankers
because the current lower level of inflation clears the path for further
monetary and fiscal easing. While the scope for further quantitative easing
and fiscal support raises future inflationary risks in the hope it will act
as a catalyst to global growth, what may be happening is the way for the
vortex of rising deflation tempered by runaway inflation will lower the value
of one currency after another. In such an environment both gold and silver
will reflect the falling values of currencies. This may well lead to positive
rising gold demand.
If gold is re-rated to a Tier I asset,
the balancing of portfolios it provides [as currencies fall in value, so gold
acts as a counter and rises] should prove a driving force to demand for gold
from commercial banks, a relatively new force in the gold market.
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