Inflation Or Deflation?

This is THE big macroeconomic debate right now. Inflation and no real growth; stagflation or a deflationary death spiral like what the Japanese suffered? How will the markets react?

In a deleveraging world, ‘Inflationists’ say that increasing the money supply to pay for all the bailouts, buying up bad assets, and generally trying to keep credit flowing by cutting interest rates will make money so cheap that prices will have to go up to compensate for the currency debasement. Money will be worth less because there is so much of it sloshing around the system. The amount of debt that countries will take on in order to print money will act as a massive drag on economic growth.

Those arguing that governments have to borrow now in order to invest, say that demand is so weak that all the money printing is doing is propping up the financial system and stopping it from going to the wall. If nothing is done, they say, there will be catastrophic consequences for everyone - trade dries up, unemployment balloons, and we end up in a depression which will take decades to get out of. According to deflationists, the main risk - and the Fed’s report from yesterday seems to take this view - is that deflation could be more than a threat than inflation.

Here are a couple of extracts from this excellent piece about this debate:

The key point is that I’ve viewed (bailout) efforts as band-aids and non-inflationary since they are merely triaging the hemorrhaging of asset prices and capital THAT ARE ALREADY OUT THERE - houses already built, capital already expenditured and consumed. As result of this, no one is going to build new housing, time shares or officer buildings, plant and equipment or such. No American consumer is going to be permitted to become more indebted or consume much beyond what he takes in. No financial institution is going to expand their balance sheet when everyone and everything is deleveraging from Peak Credit.

Indeed, the real question is whether the expansion of the Fed’s balance sheet is keeping pace with the contraction of money market credit more generally. If not, then the consequence may be deflationary.

What Does This Mean For Gold?
Gold is caught on the cusp of this debate. On the one hand, the race by countries to devalue their currencies and boost exports - New Zealand cut rates overnight by 1.5% and Australia may follow suit - seems to be pushing up the demand for gold. If the dollar weakens, gold gains traction as a ‘safe haven’ substitute - a kind of last resort reserve currency. Also if inflation does take hold, buying gold, which tends to track commodity prices, acts as a hedge against inflation. Further in times of extreme fear and market volatility, there is often a rush to gold. All of this made gold one of the best performing asset classes to have owned over the last year. These factors are still in play and give good reasons why gold will continue to rise.

But on the other hand, inflation isn’t guaranteed to happen so there may not be a need for gold to be a ‘store of value’. Despite all the money being printed, it’s not clear to me where the inflation will come from so long as everyone is forced to save more and spend less; credit remains restricted and jobs are scarce. Also to get any value out of being long in gold, you need to turn your position back into cash. This is why every few weeks we get a rush to sell gold to raise funds - it’s part of the deleveraging process. There will be plenty of selling pressure as people liquidate their assets. You could argue that gold currently looks way overpriced in relation to the rest of the commodity complex. It’s hardly moved in real terms compared to oil, which is a third of the price of its peak last year. Irrational exuberance?

How Am I Trading Gold?
I’ve got a long position on the April gold future from 850 that I am on the verge of cutting and going back short. But I can’t make my mind up. The dollar is showing some wobbles and weakening against sterling and the yen, which should be good for gold. But why do you need a hedge against inflation when all of the indicators seem to be pointing more towards massive deflation than inflation? On balance, this morning, I’m thinking that trading gold to the short side might be more profitable. Especially as I didn’t manage to get out when gold was trading above 900. So I added a short gold position, with a tight stop, on the rolling daily bet from 881 as a hedge against my long position on the April gold future. And if the April future drops below 880 and stays there for an hour or two, I’ll cut my long position altogether.

And one other thing. Everyone wants a profit, and no-one wants to get stuck in a losing position. So the selling momentum around gold could well increase as all those people like me who bought recently want their capital back intact. It’s the nervousness that adds to the volatility in the price.

More Information
More on gold’s sudden move upwards here, if you’re interested.

A couple of great programmes to watch on the BBC iPlayer: Evan Davis’ ‘When Markets Go Mad‘ (we’ve all been there…) and the story of the 1929 Great Crash.

I’ve left all my other positions intact, other than halving the size of my Barclays’ long. I’ve gone short FTSE and short S&P, as a hedge against my long equity positions.

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