Gold and Deflation
We have done a little research recently on how gold works in deflation. Along with having to read a lot of articles on the coming end of the world in the Gold related material I have come to the following conclusions based on history:
1. Since governments fear deflation much more than inflation, the root policy is to always go for inflation.
2 Deflation tends to sneak in when least anticipated so monetary authorities are always on watch for a sneak attack. (a recent example, Greenspan and Bernanke based on their public statements were broadsided by the 2007-2008 deflationary event)
3. Gold tends to drop with other assets during the initial deflation scare, sometimes quite dramatically.
4. Once the initial scare has wrung itself out, governments go back to inflation policies and gold climbs back up.
5. Interest rate policy is highly correlated with gold direction, ie. low interest rate policies push gold higher, high interest rate policies push gold lower. It seems that the nine percent interest rate area tends to be the swing point on major changes in gold direction.
Application of above to current times:
1. Ben Bernanke is deathly scared of deflation. We have all heard of how is doctoral dissertation was on the cause of the 1929 Depression.
2. QE2 as designed and stated by the Fed was to keep interest rates low, thereby fostering employment and production gains. In reality the main beneficiary has been the gold and equity markets as the speculative money, run through banks who have access to the Fed’s cheap money, has poured into the system.
3. In a sense Ben has to be happy that the country feels it has dodged the bullet and the deflation scare is over. In the short-term sense (6 to 12 months) that is probably the case.
4. What has to be unnerving to the FED, however, is that interest rates rose since the start of QE2. What that has to say to them, is that they are in reality not in charge of interest rates, just inflation boosts. Holders of government debt are in fact in charge of interest rates and contrary to the situation in 1929, much of it is in the hands of foreign entities.
5. As US debt moves to what some analysts feels is a critical level of debt, being equal to GNP, there will no doubt be more pressure for higher interest rates to entice debt buyers..
In my opinion QE2 was mostly a reaction to falling stock prices as the 1050 area of the S&P was being assaulted in late August of this year. The FED had fears that a breach of that important support level would put into place the dreaded double dip. At that time we we referred to it as just being a threat of a double dip as we we looking for market support in the 850 to 890 area because the economy was already turning upward. Bernanke had the option at that time, an option fully supported by improving economic numbers except for employment which he cannot affect anyway, to play hardball, but he took the easy way out and played overkill. This overkill will eventually go to kill as interest rates move higher.
Here is my pick of the weekend reading. My take and opinion on it is that the great middle in politics is essentially the clueless middle. We need more than that.