Deflation Scenario to be Tested
Article originally submitted to subscribers on 12th January 2007...
Is there a limit to the amount of Money the Fed can Print?
It's obvious the Fed is willing and able to print an infinite amount
So why wouldn't they?
The answer lies in the fact that if people expected a never ending blizzard of paper they would take steps to protect themselves from holding such a depreciating item. How? By buying those items whose supply remains relatively inflexible for example Gold.
Taken to the extreme, if expectations of complete and rapid money printing (debasement) became commonplace, the rush out of paper would become a MAD dash for the exits.
Therefore, in the interest of holding onto the money creation reigns, the Fed is restrained by people's expectations of how quickly their money will lose its purchasing power. That is, if expectations of inflation are low, the Fed can print a Lot and if expectations of inflation are high, the Fed can only print a Little.
Are we now entering the Print a 'Little' stage?
By 2003 the Fed had slashed short-term interest rates from 6% to 1%, the world began reflating from the Nasdaq collapse and asset prices were being fuelled by never-ending cheap money.
The problem was/is that such money had to go somewhere and the money flowed into almost every asset class including Bonds (fuelling the Housing Bubble), the stock market (large caps and emerging markets), private equity funds (fuelling M&A) and ofcourse commodities (most notably Oil and Industrial Metals).
But remember inflation expectations?
Rising commodity prices and more precisely rising Gold prices raise the red flag on inflation expectations.
To combat this, the Fed started its mini-rate rising campaign to convince the market that any inflation problem was being dealt with, thereby keeping a lid on inflation expectations.
All the while, cheap money continued to flow from other central Banks, most notably the Bank of Japan, ensuring the monetary system was well supported and lubricated whilst inflation expectations remained low.
The net result has been a global explosion in debt levels and a universal biding up of asset prices.
But alas, the laws of nature apply to markets as well. Those micro Fed rate increases have begun to take their toll. As the Yen : Dollar rate stabilized the Yen Carry Trade has also slowed. And ever so subtly the tap of Fresh Money is being stopped up.
The markets have responded through a drop in Home Building Stocks, a haphazard rise in Bond Yields and ofcourse brutal corrections in commodities such as Oil.
Now we find ourselves in a crazy situation where the Fed requires a slowdown and asset prices to fall in order to justify the next round of rate cuts and more money printing. Remember, inflation expectations must be kept low at all costs to keep the game going.
Wow! What a dangerous game.
We have entered into a Fed sponsored slowdown where an element of deflation will be allowed to enter the system. The Fed is attempting to land a debt laden Jumbo Jet. Refuel and take-off again. A lot is at stake and a lot could go wrong. Will they be successful? We'll have to wait and see.
As deflation bites over the next few months watch for a widening in risk premiums and a flight to quality which should ultimately be positive for Gold.
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