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To Inflate or Die - That is the Second Question

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Last week in the deflation/inflation argument, we only had time and space for the deflation case. In honor of the notion of equal time, we are going to strictly focus on the case for inflation this week.

In case you missed last week's Options 101 morph into Economics 101 on exported deflation born of production overcapacity (and the economic rise of China, I might add), you can get up to speed here:

http://www.optioninvestor.com/page/oin/education/opt101/2003/01-16.html

The good news is that the case for inflation practically writes itself. What I should really say is that the Federal Reserve has practically written it for us. Even if you are not into economics (and who among us actually likes to take this stuff to bed?), follow along, as the implications of inflation help us determine the direction of our investment future.

Here's how things are setting up. Deflation is dangerous and the Federal Reserve will do anything to fight it. Why is it dangerous and why fight it? Two reasons. First, if consumers are to consume their brains out (not far from reality), the prospect of buying goods and services cheaper next month will keep their collective wallets closed in anticipation that they can buy it cheaper later. Keeping the wallet closed is bad for business investment spending and corporate profits, both things that the Fed counts on to keep the economy humming. That "buy it cheaper later" notion feeds on itself.

Second, once deflation takes hold, the Fed is POWERLESS to stop it, and the Fed is loath to lose its power over the economy. 0% is the lowest achievable interest rate for the Fed to implement. The Fed can do nothing once rates hit that level. Even 0% borrowing cost is not cost effective to the borrower when prices are falling. Again, it comes back to overpaying now - even at 0% interest - when we can buy cheaper later.

Need evidence? See Japan. Though the Bank of Japan would love to see the Yen fall against the Dollar from the current roughly 115 to 150 by the end of 2003, it isn't working for them. The Yen is going the wrong way and gaining strength against the Dollar. You pretty much have to consider yourself a failure as a Japanese Central Banker if you cannot succeed at intentionally destroying your own currency. Such would be the plight of the Fed should the U.S move into all out deflation.

So given the preponderance of evidence of deflation, what are the Fed-meisters to do? The answer is very telling and was given for all the world to see by Ben Bernanke, a recently appointed Federal Reserve Governor, on November 21, 2002 to the Economists Club in Washington D.C. It isn't just hopefulness by the Fed to keep deflation at bay. It's a mission. Evidence is contained in the title of the speech: "Deflation: Making Sure "It" Doesn't Happen Here." OK, guns loaded; fire!

I'll skip most of the speech, as it sounds like most Fed speeches full of verbose qualifiers and caveats. But here are the actual words spoken that night that ought to be etched in every investor's brain if they are to prosper in the coming years. Get this if nothing else:

"U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper- money system, a determined government can always generate higher spending and hence positive inflation. ......If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation."

"The basic prescription for preventing deflation is therefore straightforward, at least in principle: Use monetary and fiscal policy as needed to support aggregate spending..."

Did everyone get that? Barnanke admits the Fed has a printing press and is intent on using it to thwart deflation. It can't be any clearer than that. It has thus become the Fed's mission to "Inflate or Die". You can bet it is going to do its darndest to inflate and has done a pretty good job, so far (though it is interesting to note that M3 money supply has actually DECREASED in the last few weeks). [Note: "money supply" is loosely defined as cash, checking, and savings deposits - there is more to it than that, but after 20 years, my memory of economics classes has become a bit fuzzy.]

Just a paragraph or two on money supply. A declining money supply right now has to be scary, even to the Fed. I don't make any guarantees on this and I am not an economist by trade. I don't even play one on TV. Yes, it's just a number to most, which doesn't affect the outcome of anyone's life. But my take on this isn't good. To me, it means that while the Fed is flooding the banking system with money, that money isn't getting lent out and ending up in consumers wallets and checking accounts, which may be an early sign that consumers are raising the white flag of consumption in surrender. As one financial author recently put it, it's like pushing on a string. More like, "You can lead a horse to water, but you can't make him drink." Perhaps the consumer horses in this economy have had all they can take.

Listen to Dan Denning of Strategic Investments: "An awful convergence of macroeconomic trends was revealed last week. Spending for the indebted consumer went up. But business spending did not. What demand there is in America is directed towards foreign goods, with the profits going overseas, further putting pressure on U.S. firms; the very same firms who have no incentive to invest in new jobs because they are already operating well below capacity. The only real question left for the economy is when the consumer will surrender." Oh boy - not music to the Fed's ears. Again, the necessity to "Inflate of Die".

Anyway, just a thought on my part. If any of you have further insight on this, I'd love to hear it and welcome to knowledge that sets me straight on the subject.

But back to the subject at hand. Any other reason that the Fed would inflate? It all goes back to deflation fears and other exporting nations wanting to weaken their currencies as a way to stimulate exports. Central bankers worldwide are competing to make their currency cheaper than the next guy's. Remember, weaker currency makes goods cheaper to buy with the relatively stronger currency. To stimulate export growth, Central Bankers need only cheapen the currency to that other find it attractive to buy the goods. That's what I meant last week by competitive devaluations.

Adds James Grant, Forbes contributor and research analyst, also one of the clearest minds in finance for thinking outside the box (He probably doesn't even know where the box is), "The world wants to reflate. Bloomberg News reminds us that, by August, the Bank of Japan, the European Central Bank and the Bank of England will all be under new management. 'With the 1970s inflation rates of 10% or more a distant memory,' the news service notes, 'the new central bankers will probably keep a lid on interest rates.' "We suspect that the new generation of central bankers will also see to it that their national mints do not lack for either parchment or pigment."

There you have it - the case for monetary inflation - which is squarely pitted against the forces of deflation. It should come then as no surprise that gold has gone from roughly $315 to $360 since Bernanke's speech and that the Dollar has caved against the Euro rising from $0.99 to $1.07 in the same period.

Good bye Dollars; hello Euros (for now); welcome gold! More on the latter after tackling real estate in this column next week.

Questions always welcome! Stay tuned and make a great week for yourselves!

Buzz



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