The Deflation
Threat /
More Thoughts on Gold & Interest Rates
Steve Saville
May 19, 2004
Below are extracts from
a commentary posted at www.speculative-investor.com
on 16th May 2004.
The Deflation Threat
There is an extremely good
article by Sean Corrigan on the inflation/deflation issue at
GoldSeek.
Of course, the main reason we think it is extremely good is that
it is totally in synch with what we've been saying at TSI for
years.
There is no doubt that the
Fed has the power to stop deflation in its tracks should genuine
deflation ever become a threat to the US financial system (at
the moment it is NOT a threat, although we are anticipating that
another deflation scare will be conjured up over the coming 6
months). This is because the Fed has the power to monetise an
unlimited amount of debt. The question, therefore, is whether
the Fed will CHOOSE to make use of all its powers in its fight
to maintain the expansion of credit.
We think the answer to this
question is clearly provided by the actions of the Fed over the
past 10 years. Or, as Mr Corrigan eloquently puts it in the aforementioned
article, " ...the recent history of bail-outs, emergency
rate cuts, the instant provision of vast swathes of 'liquidity',
and other such interventions undertaken by the central banks
in the face of anything from the Mexican crisis of late-1994,
through the Asian Crisis of 1997/8, the Long-Term Capital Management
fiasco, the Dot.com bust, Y2k, 9/11, and so on and so forth,
argues strongly that whenever the US financial system (in particular)
is threatened, the floodgates are opened without further ado,
even if 'rules' have to be infringed and the dictates of best
practice eschewed in the process."
The source of a lot of the
past, present and probably future confusion surrounding the inflation/deflation
issue is the linking of the words inflation and deflation to
rising and falling prices. However, prices rise and fall all
the time for reasons that have NOTHING to do with inflation or
deflation. In particular, a drop in prices has absolutely nothing
to do with deflation if it is not CAUSED by a contraction in
credit. Failure to understand the true meanings of these terms
typically results in the mixing up of cause and effect and leads
to many logical errors.
But couldn't a large fall in
asset prices bring about a contraction in credit, which, in turn,
causes prices to fall throughout the economy and sets in motion
a vicious circle of contracting money-supply and falling prices?
In theory, yes, but the historical
record of fiat currencies shows that such an outcome is extremely
unlikely. For example, if we look at what happened in the US
over the past 6 years we see that each sharp decline in the stock
market was followed by a sharp RISE in money-supply growth. And
if we take a look at post-bubble Japan we see that massive declines
in the stock and property markets over many years did NOT result
in deflation even though the Japanese central bank chose not
to go down the route of aggressive debt monetisation (the Japanese
chose, instead, to rely almost entirely on deficit-spending by
the government). So what is the basis for expecting the US to
experience genuine deflation over the coming 12 months when the
US central bank has clearly stated, and has demonstrated by its
actions, that it is willing to monetise anything and everything
should the need arise? In our opinion, there isn't one.
Deflation scares will, however,
continue to happen. In fact, it seems that we must have at least
one deflation scare per year in order to provide cover for the
Fed's inflation agenda and to prevent most people from perceiving
what's really happening in the financial world.
Gold and Interest
Rates
As discussed in previous commentaries,
the notion that gold dropped from $430 down to $375 due to rising
interest rates only makes sense in the context that fears of
higher short-term interest rates prompted a general de-leveraging
within the speculating community. In other words, speculators
who borrowed money to bet on the "inflation trade"
were forced to cover as soon as evidence began to appear that
interest rates were set to rise, even though the Fed was, and
is, unlikely to act with anywhere near enough aggression to reverse
the inflation tide. And the downturn was helped along by the
fact that small traders -- the traders that tend to be less well
capitalised and more vulnerable to being 'shaken out' of their
positions when price reverses course -- had built up a substantial
net-long position in COMEX gold futures.
The thing is, regardless of
the reason for the drop in the gold price the drop, itself, removes
some of the upward pressure on interest rates across the curve
because gold is widely perceived to be a leading indicator of
inflation. Therefore, the weaker gold gets the less likely it
is that rising interest rates are going to become a genuine problem
for the gold market and the more likely it is that the Fed will
be given the freedom to continue with its pro-inflation policies
for a while longer. In fact, there were some subtle signs last
week that the upward pressure on short-term interest rates was
already starting to abate. For example, during the week before
last the yield on the 13-week T-Bill moved above the Fed Funds
Rate (FFR) for the first time since early 2002, but by the end
of last week it had dropped back below the FFR (refer to the
chart below). March-2002 was the only other time within the past
three years that the T-Bill yield moved above the FFR and on
that occasion it also quickly moved back below the FFR. Furthermore,
the next move by the Fed turned out to be a rate REDUCTION.
We think the next move by the
Fed will be a rate hike -- most likely a 0.25% hike at the June
FOMC Meeting -- but we seriously doubt that the Fed will get
aggressive on the inflation-fighting front until the markets
force it to do so. And with the gold price below $400 the pressure
from the markets probably won't be that great.
 Steve
Saville
email: sas888_hk@yahoo.com
Hong Kong
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