Inflation and Deflation

Have you followed the recent rise in value of the U.S. dollar? Through late summer, the dollar increased in value against the euro, as well as the yen and numerous other currencies.

Also, as August rolled on, gold fell from a price over $900 to under $800 per ounce. And oil tumbled from a price point near $145 to under $100 per barrel. This is quite a drop. And a lot of observers credit the drop to the strengthening dollar. So what’s going on?

Usually, a currency strengthens when there is some sort of good news about the underlying economy. But is this the case for the U.S. and the dollar?

The banking crisis is still with us, as is the ongoing housing meltdown. And many insiders say that there are still more tough innings in this game. So where is the good news?

Indeed, Kenneth Rogoff, an economics professor at Harvard and the former chief economist of the International Monetary Fund, recently predicted that there is still more bad news to come from the worldwide credit crunch and financial turmoil. According to Rogoff, “The U.S. is not out of the woods. I think the financial crisis is at the halfway point, perhaps. I would even go further to say the worst is to come.”

Rogoff added an ominous prediction, stating, “We’re not just going to see mid-sized banks go under in the next few months. We’re going to see a whopper. We’re going to see a big one — one of the big investment banks or big banks.”

Looks like he turned out to be right on the money.

So if the U.S. financial system is in such a precarious state, is the rise in value of the dollar really justified? Will it be good for the U.S. economy to have a major bank failure? Or on the other hand, will it be good for the economy if the U.S. government has to step in to bail out a large bank? It all seems like a “lose-lose” proposition.

Another well-respected commentator, Richard Russell, who has published Dow Theory Letters since 1958, believes that we are on the eve of world deflation.

According to Russell, the big problem facing the world economy is not inflation, but deflation:

“From what I see, the markets are telling us to prepare for hard times, and a global spate of the worst deflation to be seen in generations. This is why gold has been sinking, this is why stocks have been falling — big money, sophisticated money, is cashing out, raising cash, preparing for world deflation.”

According to Russell, “Smart money is selling into the stock market, day after day.” People and institutions are raising cash. When deflation rules, this will usher in a strong dollar.

Russell offers an illustration for why people are raising cash:

“Look, if you have $5 million and you are receiving only 2% in interest on your money, that’s only an income of $100,000 on your $5 million. Big money realizes that in a deflation, you need a mountain of cash to keep up your lifestyle.”

So Russell anticipates an era of deflation, accompanied by low interest rates. Hence the need to raise cash to support an income stream over time.

Then again, what if the markets are anticipating an increase in interest rates over the medium to long term? Could this be prompting a rise in the value of the dollar? Think of how much new “money” is floating around out in the world due to just the recent creation of credit as the Fed has bailed out insolvent banks and investment houses.

Where has all that newly created money gone? It’s lurking out there, somewhere in this world. And that new money could show up at any moment, bidding up the prices of whatever happens to be the “big thing” on any given day. Thus, while Richard Russell thinks we are on the eve of deflation, we are also confronting the specter of inflation.

The last historical experience the world market has had with high inflation rates and stagnant growth was back in the late 1970s and early 1980s. To combat inflation, then-Fed Chairman Paul Volcker increased interest rates to double-digit levels. High interest rates hit the economy like a ton of bricks, but that was the idea. High interest rates broke the back of inflation for a generation.

You have to look back even further, to the 1930s and the time of the Great Depression, to find the last long-term era of deflation. What do you see? The price of gold and gold mining shares actually increased during the 1930s.

The key to the rising price for gold in the 1930s was the effort by President Franklin D. Roosevelt to raise the nominal price of gold from $20 to $35 per ounce. It was still — in many respects — a gold standard world back then. But in raising the gold price, FDR also indirectly spurred the market capitalization of much of the mining industry.

One thing to keep in mind is this. We know a few things about inflation, both practically and from economic theory. We don’t know nearly as much about deflation. If deflation shows up at the door, will anyone really know what to do about it?

So this prompts the question. Where are prices for precious metals headed? If we encounter deflation, will we just retrace the run-up of the past six years or so? Will we see gold back at $300 per ounce, and silver at $3 per ounce? I doubt it.

I think that we will look back at the summer of 2008 as a time when precious metals had a correction after a relatively quick move upward. To put it in terms of technical analysis, the prices “outran their support.” It’s like the tanks of Gen. George Patton outrunning the fuel trucks in the closing days of World War II. Patton had to stop advancing, while the trucks caught up.

When the dollar strengthened in mid-2008 — for a variety of reasons — it prompted a pullback in prices for precious metals and the related mining shares. If you are cautious, you will hold cash and sit it out. If you are bold, you’ll look for bargains and buy shares.

Long term, I don’t think you will get hurt by buying into share price weakness. Over the long term, precious metals and the mining shares should still continue to rise in a market in which dollars are getting cheaper and things of real value are becoming scarcer.

Regards,
Byron W. King
September 30, 2008