With the price of stocks and other assets beingdeflated daily, you'd think a column forecasting gold deflating alsowould be no big deal - gold, after all, is just one more asset. Butrarely has this column generated as much e-mail as the last one, whereletters from miffed gold bugs were outnumbered by puzzled readersasking how deflation could co-exist with massive money printing. Won'tglobal money creation bring inflation back very soon?
Normally I don't like to repeat a topic, but since inflation is sucha key factor in investments, and since there seem to be misconceptionsabout its full causes, let me elaborate on these, then go into theimplications.
Inflation's classic definition is "too much money chasing too fewgoods." The more modern definition is, "money supply exceeding moneydemand." And it's here that the misconception arises, because "moneysupply" is not just money Uncle Sam has printed. The latter isequivalent to how many boxes of bullets were produced in the Fedammunition factory and put on the shelf - this is the mere "monetarybase."
The key factor is how many times each money bullet is fired, thenpicked up and refired. This is the so-called money velocity. When moneybullets are used and reused quickly (when there's high economicactivity), the monetary-ammo base has high firepower, as each dollarturns over many times a year.
On the other hand, when people (and banks) are afraid to buy or sellor lend, such as now, Uncle Sam could print fresh money until he ranout of ink, but if these extra money bullets stay unfired, inflationwould stay dead. That's why money creation alone does not forecastinflation, without considering money use also.
In fact, there are models that do just that, using both demand andsupply factors. And right now they forecast more deflation ahead.(Unlike most economic models, whose forecasts are about as good as youraverage fortune teller's, these models have been well tested and foundto do a decent job.)
An excellent U.S. firm by the name of Hoisington, which manages bondinvestments, gives an excellent description of one such model on itswebsite, and you are welcome to look it up. Why, even the Bank ofEngland recently said inflation would likely be 0 per cent to minus 1per cent - and could go lower still, unless interest rates are cutagain.
Will rate cuts help the market? Eventually they will. But won't theyignite inflation also? That one is unlikely. Because not only has thenewly created money remained unused, but the world is now awash withstuff, so too little active money is chasing too many real goods.
Indeed, if the world were a company, you could say that itsinventories are bulging, as several countries keep producing stuff tokeep their workers employed. Oil, for example, is so abundant, that youcan buy it now (the January, 2009, contract) at $50.75 (U.S.) a barrel,store it for a year, and sell it for delivery at December, 2009, for$60.29, or 19 per cent higher. This is a fabulous riskless return - if you could find a place to store the oil, which you probably couldn't - and if you found someone to lend you the money for the buy and for the short, which you might not.
But oil is not the only overabundant commodity. Aside from unsoldU.S. homes, there are also rising inventories of unsold cars, andairplanes, and machinery - and, yes, food.
Whereas a year ago everyone was sure food would be the nextscarcity, the world now has too much of it. Wheat stocks are at threeyears' high, soybeans at four and corn at two. There are piles ofcopper and platinum and, yes, silver.
There's too much beef, which can now be fed with cheap corn andcheap wheat, and sugar, too, is abundant, as is coffee, whose pricefell even as a hurricane threatened to hit Vietnam, where much coffeeis grown. Needless to say, the price of all these has been falling,alongside stocks, and yet more stuff keeps piling up, as dictatorialcountries that need to keep their population employed keep producingstuff into inventory - which is one of the reasons OPEC (Saudi Arabia,Venezuela, Iran, and other such enlightened regimes) can't cut oiloutput.
China (another non-democracy) has also been piling up cotton, whichit has been buying from domestic producers, then handing over todomestic users at a discount, to keep employment high. But Chineseclothing manufacturers have been going bust (worldwide demand for fancyduds is falling), so China may soon have to export these rising piles.It is already beginning to export more coal for similar reasons, andmay soon do the same with wheat and corn, as would Russia and Australia.
And what would this do to commodity prices? You got it. Down further they may go, keeping deflation going. But for how long?
That's a good question, because when the economy finally turns (norecession lasts forever), and when people and companies start buyingagain, all the freshly created money would be used, and repeatedly, andthen inflation could heat up fast.
But for the next year or so, inflation is likely dead. So eventhough gold may pop here, in a year it could be much lower. Forget itand other inflation hedges for now, and stick to deep value, cash, cashgenerators - and no debt, which for the next while couldn't be inflatedaway.
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