What Does Deflation Do to Gold Prices?

The prospect for Gold Prices in a grim economic environment...

AS THE world becomes increasingly familiar with the grim economic and financial climate investors are realizing that economic life is far from simple and that growth is not something that governments or central banks can turn on or off, writes Julian Phillips at GoldForecaster.

Likewise for all the clever construction of inflation and deflation measurements, the public in general are beginning to realize that overall inflation and deflation are far too simplistic to be given more than a 'seasonal influence'. The reality is that you can have both at the same time.  

The reality is also that there are times when deflationary paths, in some sectors, join with inflationary paths in others, to cause economic damage that is caused by both being destructive [and not ruling each other out in the addition of a minus to a plus -e.g. inflation at 2% with deflation at 2% does not make zero – but the two combined have a damaging effect of 4%]. That's what is soon to happen.

Inflation in the US is running at 2.4% per annum (ahead of the food inflation that is on its way from the drought). Deflation in asset values in housing is slowing but the slowing of the velocity of money alongside the falling value of fixed interest securities and a slowing economy, join together to undermine growth, the future and confidence. With a desperate need for increasing economic growth to stave off the destructive impact of inflation plus deflation, the failure to produce economic resuscitation seems more likely, by the day, to point to a new downturn. Then a very different type of inflation to food inflation will come to be. 

It is excessive monetary inflation, which as we have seen does little to kick start growth. It simply postpones recession. Subsequently, the deflation that happens to asset values reaches down to the value of the buck in your pocket. That's when inflation really takes off to attempt to compensate for growing deflation.

Where are we in this process now? We are still at the start of a serious downturn as the Fed's monetary stance, while very positive, has failed to add real growth to the US. Chairman Bernanke said last week that "rogress in reducing unemployment is likely to be "frustratingly slow" and repeated the Fed is ready to take further action to boost the recovery, while refraining from discussing specific steps. 

"The US economy has continued to recover, but economic activity appears to have decelerated somewhat during the first half of this year," Bernanke told Congress. The Fed is "prepared to take further action as appropriate to promote a stronger economic recovery," he said. 

Bernanke said growth is slowing as business investment cools in response to the European crisis (which is now worsening) and the prospect of fiscal tightening in the US. At the same time, households are restraining spending as unemployment remains elevated and credit is hard to get.

The danger he is now facing in adding more quantitative easing is that he will add more newly created money, without producing the desired effects of raising employment. The net effect will then be to cheapen the value of money itself.

The so-called 'fiscal cliff' would push the economy into a "shallow recession" early next year, Bernanke said. (Unless Congress acts, $600 billion in tax increases and spending cuts are set to take effect automatically at the start of next year.)  

Additional negative effects would result from public uncertainty about spending plans, including the debt ceiling. The most effective way that the Congress could help to support the economy right now would be to work to address the nation's fiscal challenges in a way that takes into account both the need for long-run sustainability and the fragility of the recovery. The Fed chairman said Europe's financial markets and economy "remain under significant stress," and that's creating "spillover effects" in the rest of the world including the US.

That said, European developments that resulted in a significant disruption in global financial markets would inevitably pose significant challenges for the US financial system and US economy," he said. It is against this backdrop that we now look at the way forward for gold and silver in the days to come.

The definition of 'deflation' is: 

While inflation erodes the value of money, which progressively buys less and less per unit, deflation makes money worth more. That makes people and businesses less likely to spend it – consumers because they expect even better deals if they wait, and businesses because it's less profitable to produce goods or services that will bring a lower real return. These factors can feed on each other to produce a downward economic spiral, as happened in the Great Depression.

To us this is over simplistic as it describes only one picture of deflation. In a global economy, the definition needs to account for the value of each currency area suffering deflation. After all the balance of payments comes into play and in turn the international value of the currencies suffering from the aberrations of deflation and inflation.

As brought out in her recent article, Rhona O' Connell of precious metals consultancy Thomson Reuters GFMS pointed out that in "The Golden Constant", written by Roy Jastram over 30 years ago and recently re-released including fresh material by economist Jill Leyland, tells us that in the US there have been three recorded deflationary periods and gold increased its purchasing power in each of them, by between 44% (1929-1933) and 100% (1814-1830). 

Please note that this was at a time when the Gold Price was fixed and unable to rise. Nevertheless, the purchasing power of currencies fell against gold. We learn from this that while governmental controls do work, they work only up to a point then are overwhelmed by market forces.

The forces at work in the financial world now are pointing towards a coming increasingly deflationary picture. If it does take hold then the deflation of cash will overwhelm any quantitative easing the Fed may produce. If the Fed were then foolish enough to print at a pace that keeps up with accelerating deflation, then, it will simply create a hyperinflationary environment. But will they have a choice. The same environment will happen in many countries in the developed world but at different times and at a different pace. 

The World Gold Council did some useful work on this through Oxford Economics who found that gold is useful to investors in various economic scenarios, not only during high inflation periods. The research found that while deflation leads to a rise in the US Dollar it maintained that the destructive impact of deflation on traditional assets was likely to outweigh the US Dollar effect and provide a boost to gold.

In fact, the analysis showed that gold would outperform equities and housing in a deflationary scenario.

Additionally, a disinflationary (and ultimately deflationary) environment provides central banks with more room to manoeuver on stimulus. For example, on 5 July, the Bank of England, People's Bank of China and the ECB acted in unison by announcing accommodative measures in response to weak economic figures. These accommodative measures should fuel the risk of consumer price inflation further down the line while providing a temporary boost both to asset prices and capital flows to emerging markets. It is our belief that if these measures again fail [as they have done to date] central banks will be forced by their political masters [despite their assumed independence] to print more stimuli. This is how deflation will force inflation at an accelerating pace onto the scene. 

Further, the apparent dependency on central bank support for an ailing global economy highlights its chronic weakness. The combined weight of uncertainty and hope of central bank action will maintain higher asset price volatility but faces the danger of triggering runaway inflation in the back of rising deflationary pressures.

Right now, inflationary pressures may be receding in various regions, but there are underlying trends to suggest that deflation risk has increased. This challenging environment tends to be conducive to Gold Investment

Temptation beckons central bankers because the current lower level of inflation clears the path for further monetary and fiscal easing. While the scope for further quantitative easing and fiscal support raises future inflationary risks in the hope it will act as a catalyst to global growth, what may be happening is the way for the vortex of rising deflation tempered by runaway inflation will lower the value of one currency after another. In such an environment both gold and silver will reflect the falling values of currencies. This may well lead to positive rising gold demand. 

If gold is re-rated to a Tier I asset, the balancing of portfolios it provides [as currencies fall in value, so gold acts as a counter and rises] should prove a driving force to demand for gold from commercial banks, a relatively new force in the gold market.

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JULIAN PHILLIPS – one half of the highly respected team at GoldForecaster.com – began his career in the financial markets back in 1970, when he left the British Army after serving as an Officer in the Light Infantry in Malaya, Mauritius, and Belfast.

First he worked in Timber Management and then joined the London Stock Exchange, qualifying as a member and specializing from the beginning in currencies, gold and the "Dollar Premium". On moving to South Africa, Julian was appointed a macro-economist for the Electricity Supply Commission – guiding currency decisions on the multi-billion foreign Loan Portfolio – before joining Chase Manhattan and the UK Merchant Bank, Hill Samuel, in Johannesburg.

There he specialized in gold, before moving to Capetown, where he established the Fund Management department of the Board of Executors. Julian returned to the "Gold World" over two years ago, contributing his exceptional experience and insights to Global Watch: The Gold Forecaster.

Legal Notice/Disclaimer: This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment. Gold Forecaster/Julian D.W. Phillips have based this document on information obtained from sources they believe to be reliable but which it has not independently verified; they make no guarantee, representation or warranty and accepts no responsibility or liability as to its accuracy or completeness. Expressions of opinion are those of Gold Forecaster/Julian D.W. Phillips only and are subject to change without notice. They assume no warranty, liability or guarantee for the current relevance, correctness or completeness of any information provided within this report and will not be held liable for the consequence of reliance upon any opinion or statement contained herein or any omission. Furthermore, they assume no liability for any direct or indirect loss or damage or, in particular, for lost profit, which you may incur as a result of the use and existence of the information, provided within this report.

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