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Thursday, September 23, 2010

Deflation..We Don't Need No Stinkin' Deflation......

Reading between the lines in the markets is a tricky business; however, there are sign posts that can help divine the probable future. At this point in time everywhere you look at least in the mainstream media, economists and officials are being shown as fearing deflation. If this message is true then why are Gold, Silver and Commodities rallying?

The FED in its latest policy statements has proclaimed that it stands ready to do anything and everything to jumpstart the economy and prevent deflation. The FED stands ready to pour money in to the system and monetize bonds or any other asset class at will. The FOMC feels that it has the wiggle room to monetize and purchase whatever it feels necessary since the inflation rate is “somewhat below” its target. The deflationists including the FED are wrong in my opinion and the gold, silver and commodity markets are beginning to reflect this reality.

The measures used to gauge inflation, the CPI and PPI are both Jerry rigged indexes that are used to manage government COLA(cost of living adjustments)  payouts for programs tied to the underlying indices; like social security and Medicare.

The CPI for example is altered whenever any of its components rise in price, for example as the housing market in the early 2000’s was flying and  in order not to reflect that inflationary input housing prices were replaced in the equation. The housing price component was subsequently replaced with owner’s equivalent rent to stem the rise. To put this phenomenon in other terms if steak is part of the basket of goods and services and steak prices rise then hamburger or chicken may be substituted in place; as the assumption is that the consumer will switch to the less costly substitute, instead of reflecting true costs.  Additionally, a practice called hedonic indexing is used to contain the inflation driving inputs. The way this indexing works is as follows: let’s say that a computer costs $1,000 in 2009, but in 2010 a comparable model cost $1,200. The $1,200 computer maybe reflected as costing $1,000 in the indexing process because the indexing methodology takes in to account the technological upgrades like a faster processor or some other additional feature. As a result of the incremental improvement in technology they “rate” the $1,200 computer as truly costing $1,000 due to the fact that you are getting more bells and whistles; regardless of the fact that you are still paying the $1,200. Don’t you wish that you could hedonically index your bills, groceries or taxes?

So the fact that the FED relies on faulty statistics that are taken at face value at least by the mainstream media and politicians, which gives them cover to carry out their monetization schemes.  I would contend that there is inflation in the system and it is being masked by two factors: 1) faulty statistics and 2) pent up dollars residing outside the US.

The assumption that the statistics are faulty comes to light when you live and shop in the real world there is inflation. I say this because everything you need like food and healthcare goes up in price year after year while the assets and things you may want like stocks, home prices or Plasma TVs are either flat or down. Of course you can’t eat your plasma TV so that doesn’t really help you in the inflation scenario.

As for the second point, the pent up dollars worldwide by itself is not inflationary at least not at the moment, but instead it sits and waits for the most inopportune time. If you are at all familiar with electronics you know a capacitor is an electronic device the stores a charge that can be discharged at a later point. The continual US Trade deficits have charged the “inflation capacitor” to a very high level and there are Trillions of dollars that are waiting for a catalyst to be discharged. In essence this is a future source of inflation.

In my estimation the deflationist camp along with the FED are making a poor assumption that there is no nor will there be any inflation. The deflationists feel that due to the size of the debt that all the destruction of debt will have a deflationary impact regardless of how much the FED prints they cannot offset the downward pressure. I would also point out just as the Wall Street disclaimers go “past performance is not a guarantee of future performance”, just because inflation has not roared yet does nto mean that it won’t rage in the future.  I would contend that there are four factors that will stoke inflation and that the deflationists have the timing backwards, meaning that inflation will precede a true deflation.

First, the FED will print and monetize at will as they have demonstrated in the recent past by doubling their own balance sheet and creating as steep rise in the money supply.

Second, the FED is working overtime to accomplish a “devaluation” of the dollar, which is why Timmy “Turbo Tax” Geithner was out brow beating the Chinese to try and coax them in to revaluing their currency. Whenever you hear the FED or Treasury speak about some currency being undervalued it is because they want the dollar to devalue against all currencies to spur trade and growth. Realistically they also want to devalue the dollar as a way to arrest the perceived deflation, which is exactly what FDR did during the “Great Depression”.  This devaluation will lead to inflation as everything will cost Americans more especially since we import so much of what we consume.

Third, the “inflation capacitor” effect will drive foreigners to repatriate a very significant portion of dollars that currently reside outside of our borders. Once foreigners recognize that the dollar is depreciating they will not want to hold them instead they will want to get value for them. For many years currencies have been viewed as a store of value and medium of exchange, but once the devaluation takes hold the store of value aspect will evaporate.

Fourth, once the repatriation and devaluation of the dollar begins the FED and Treasury will find it increasingly difficult to finance the monumental deficits and the unconventional methods that the FED now talks about will become common practice. The FED will be forced to monetize both for funding and to keep interest rates from going through the roof by purchasing treasuries further fueling inflation.

The risk is that the momentum of inflation rises as people worldwide see the store of value aspect of the currency continually reduced, which could result in a hyperinflation. To understand one of the reasons inflation itself occurs is because of excessive money printing, but combined with a loss of confidence in the currency can result in a hyperinflation. Let’s hope it does not ever come to hyperinflation as that is something I believe no one would escape unscathed.

It is my contention that the reason behind the rise in Gold, Silver and Commodities is a canary in the coal mine and not a bubble as is starting to be widely pushed in the media. You can protect yourself if you place money in the right areas and the canary is chirping.

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