Random Thoughts on the Passing Scene

In some private emails I have received some of the writers have expressed fears of a 2008 type meltdown in the precious metals whenever they see me use the word, "deflation". Let me try to address this somewhat here on the website so as to avoid having to make an individual response repeatedly.

First of all, when I use the word, "deflation", I am talking more about the symptoms rather than the causes. My understanding of the actual word is a reduction in the money supply evidenced by falling prices. It is the latter part of that sentence I am particularly interested in. For comparison's sake, when I use the word, "inflation", I am also more interested in the symptoms, i.e. rising prices, rather than the causes behind it which is an increase in the money supply not matched by an increase in productivity.

Regardless, the point I am making when talking about the forces of deflation battling it out against the forces of inflation, is one which means a period of falling prices versus a period of rising prices.

As you aware of by now, the Fed has been at war with the forces of deflation ever since the credit crisis erupted with the failure of Lehman Brothers back in the summer of 2008. Lehman was not the cause; it was merely the first victim. The result was a massive unwinding of highly leveraged speculative positions which drove asset prices lower across the board. Whether it was equities or commodities, it did not matter. They were all taken down hard as the Yen carry trade was unwound and money flowed back into the carry currency (the Yen) and into the Dollar as those short positions were lifted.

Enter the Fed into the fray. They began round one of QE which consisted of buying up the Mortgage Backed Securities and other alphabet-named securities which were plummeting in value and threatening to wipe out the balance sheets of the big banks who were greedy enough to buy and sell those things. That combined with the TARP program provided an enormous surge of liquidity into the markets which lifted both equities and commodities across the board. You had a classic example of the Fed ramping up the money supply in order to stave off deflationary forces. The policy was deliberately inflationary and had its intended affect. It also drove the Dollar sharply lower.

When QE1 began winding down, both the commodity markets and the equity markets began fading off their peak levels. With the economy showing that it lacked sufficient traction on its own to be able to grow at a sufficient pace to generate new hiring or one that made policy makers feel comfortable, QE2 was announced and then implemented. That had the immediate effect of unleashing inflationary forces into the economy in the sense that the liquidity it produced through the increase in the money supply shoved equity and commodity prices higher once again. Once again the forces of deflation (falling asset prices) were beaten back and once again the Dollar moved lower.

Now that QE2 is ending and the economy still shows no signs that it is growing at a pace strong enough to turn the labor markets around, prices of assets are dropping once again. Both commodity and equity markets are moving lower. In other words, this is a deflationary environment although it must be pointed out that the move lower in prices is starting from a very high level in the commodity sector as a whole. Gold is near $1500, crude oil is closer to $90, and corn is close to $7.00. None of these price levels can be considered cheap. So please keep this in mind when I use the word, "deflation", that I am not saying corn is headed back to $3.50, crude oil to $35-$40 or gold to $680 - $700. I am merely saying without the Fed created liquidity to goose up the money supply, prices are responding to the decreasing liquidity and are moving lower, albeit from a higher level. Eventually this will show up at the retail or consumer level but there will be at least a 3-4 month lag, if not a bit more. Prices will come down but will still remain high by historical standards.

This is one the reasons that I believe we will see another round of QE if Bernanke and the Fed feel it is warranted, even though they will face criticism should they do so. You will recall that throughout the rise in commodity prices, the Chairman repeatedly stressed in his testimonies before Congress and in his speeches that the rise in commodity prices was moderate and was temporary. I disagreed then and still do now that the rise was moderate (a move from below 400 in the CCI to near 680 in the CCI is not "moderate") but we all must admit that the index has come down lately and so have the prices of most commodities at the various commodity futures markets.

Having set a benchmark with these extremely high prices, any move lower in commodity prices will be measured against that new benchmark. Should the stock market take out a major downside support level and the economic data turn from bad to worse, Bernanke could rightfully argue that he has "upside room" for another round of QE in terms of commodity prices seeing that they are off recent highs. In other words, the public has now been conditioned with a spike to high prices and any move down from those levels will be seen as relief even if the price stabilizes at a new, permanently higher price level. When corn moves from $3.50 to nearly $8.00, a drop down towards $6.50 will be seen as a bargain even though the price is now $3.00/bushel higher than it was a mere 3 years ago. Same goes for crude oil. A drop from $120 towards $90, or even $80 or $70 will make the stuff look dirt cheap even though it will be trading at twice the price it was back in 2008. The list could go on and on.

What we are seeing then is a sort of three steps forward, two steps back in the commodity markets in terms of prices. The public, whether it realizes it or not, has now been conditioned to accepting the new and permanently higher price levels some of which are tied directly to the loss of purchasing power of the US Dollar. The new NORMAL is higher prices. When another round of QE comes our way, the drive to the former peak will be seen as inflationary but the impact will not be as psychologically devastating as was the first surge to these record highs. The next time it will be met with more of a yawn unless prices surge past these old peaks. Then the cries of inflation will arise once again, the Fed will face another round of criticism and the cycle will be repeated as they back off from stimulus yet again.

In such a fashion will the battle between the forces of deflation and inflation play out with the loser being the middle class and those who do not realize what is happening to their way of life.