Inflation worries boost the gold price

What is inflation? On the Federal Reserve's website, a cartoon eagle explains to children that inflation is 'the general price of goods and services rising'. And the eagle wouldn't lie to your kids, would it? Well, gold investors have been following another inflation measure - and the classic 'inflation hedge' has been hitting multi-month highs.

Remember when soaring oil prices threatened to push inflation higher? Jean Claude Trichet at the European Central Bank warned again last week that rising energy prices risk pushing wages higher, leading into an 'inflationary spiral'.

But Monsieur Trichet must wish that the ECB really faced such a simple problem! Back in 2004/06, the world's monetary masters could blame soaring oil and gas prices on greedy speculators in London or state-subsidized factories in eastern China.

Falling energy prices, however, really screw things up. How to explain away the rising cost of living when energy prices are lower from this time last year?

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'A decline in oil prices will lift European consumption,' warns Stephane Deo, chief European economist at UBS in London. He sees broader demand-driven inflation ahead as a result.

In the US, lower oil prices are 'worth three interest-rate cuts' reckons David A. Rosenberg, chief North American economist at Merrill Lynch in New York.

'Who needs the Fed, really, in this environment?' he asks. Who indeed?

And in Tokyo, the Bank of Japan is now terrified that falling energy costs will show up in its basket-case inflation data. Lower fuel prices might unmask the ugly reality of falling wages and shop prices more than 12 years after deflation first bit.

'Given a decline in crude-oil prices, we can't rule out the possibility core prices will slow to near zero in mid-2007 or even become negative,' says Ryutaro Kono, chief economist at BNP Paribas Securities Japan.

Not that deflation ever did actually bite Japan, of course. Its monetary base doubled in size in the 10 years to June 2006. Deflation classically defined as a shrinking supply of money never happened. And outside the glass towers of Wall Street, Tokyo and Frankfurt, falling oil prices haven't done much yet to slow the march of deflation's evil twin so far in 2007.

Germany's biggest union, IG Metall, could ask for as much as a 7% pay increase when wage talks begin next month. In the United Kingdom, the state sector teachers' union is asking for 4.4% or more in a bid to beat the current rate of increase in the Retail Price Index, now rising at its fastest pace since 1991. Back then, Sterling interest rates were nearly twice what they are today nominally, at least.

The UK's latest data also says the Pound Sterling has lost half its purchasing power since 1987. The cost of housing has more than quadrupled versus the British currency. But if we only see these phenomena as rising prices and then call them 'inflation' we would be ceding round to the central bankers.

What is inflation?

'Inflation is a general rise in prices across the economy,' says the Bank of England. Most everyone agrees when they talk about 'inflation' in its everyday sense. The world's oldest central bank, the BoE runs a website to teach schoolchildren about economics. So does the US Federal Reserve.

Its 'Kids Page' is hosted by a cute cartoon of the Fed's bald eagle. He looks mighty grand in his Uncle Sam hat and necktie. And he agrees with the Bank of England, too. 'Inflation means the general level of prices of goods and services is increasing,' says the Fed to America's school pupils.

The eagle wouldn't lie to your kids, right?

Professional analysts think of inflation as rising prices, too. 'Most gold investors will be focused on any signs of inflation,' reckoned one metals analyst in London earlier this week. He was referring to the Fed's interest-rate decision last week, to be followed by a slew of data on Thursday and Friday.

But investors seriously worried about rising prices in the shopping malls and supermarkets didn't bother to wait for Dr.Ben to speak or for CNN to pick apart the personal income and spending data...jobless numbers and welfare claims...auto and truck sales...factory orders or hourly earnings reports.

Gold made a decisive break above $650 per ounce. By Thursday, it was trading at a 7-month high. Given that gold's the ultimate 'inflation hedge' for worried investors, however, it's hardly surprising.

Inflation and the money supply

"Inflation is an increase in the money supply," as The Bullion Report of 1801 put it. The Report was written in London four years after the Bank of England stopped swapping bank-notes for gold. Great Britain was at war with France, and every time Napoleon looked ready to sail across the Channel and invade, people ran to the banks and demanded gold in exchange for their paper bank-notes.

Paper money, after all, was only as good as the government's promise to swap it for gold. It's not even that good today. Dollars, Pounds, Yen and Euros are just a promise to give you more promises. 'Payment in Kind' like this has only just reached the corporate debt markets; many high-risk borrowers in Europe are now issuing bonds that only pay out in fresh bonds, rather than real cash. In the currency markets as in your pay packet payment in kind is all the world's had since the US Fed finally stopped exchanging Dollars for gold back in August 1971.

Today the US money supply is rising faster than any time since 2001, back above 12% year-on-year according to one new analysis of the missing M3 numbers no longer reported by Washington. Each Dollar loses value as the flood of new Dollars over and above growth in the economy rises higher. It's the same story in the UK, where the flood of Sterling is now rising more than 10% year on year. There are also 9.4% more Euros in the world than there were this time last year too the fastest rates of money supply growth since 1990.

Inflation in the emerging markets

It's not just the developed world suffering from a surfeit of money. 'Underlying inflationary pressures remain,' the central bank in Mumbai, India warned on Monday. It looks likely to raise Rupee interest rates later this week, but Indian savers and investors won't expect that to slow the surge in debt and new money flooding India's economy. It's driving prices higher as the value of each Rupee shrinks too just like in Europe, the UK and United States.

India's money supply growth as measured by M3 has accelerated to 20.3% year-on-year reports the Hindu Business Line. What might Indian citizens do to protect their wealth against the falling value of each Rupee they own? In many poorer regions of the sub-continent, gold currently acts as a kind of savings account. India accounted for one ounce of gold in every five sold anywhere last year. Its poorest consumers might soon be glad they haven't had access to more 'developed' or 'sophisticated' banking services.

Slow, steady growth in the supply of gold sits in stark contrast to the runaway growth in today's global money supply. And more evidence that the supply of gold is actually slowing further came this week from Moscow. The Itar-Tass news agency reported Monday that Russia's gold output fell in 2006.

Down from 157 tonnes to 152 tonnes according to Valery Braiko, head of the Russian Union of Gold Producers, Russia's gold-mining output fell thanks to problems at smaller mines working alluvial deposits gravel, mud and sand deposited by rivers carrying gold ore out towards the sea. Some 70% of these mines are officially bankrupt in Russia, so they cannot pay taxes and social deductions. Thanks to the tax demands from Moscow, in fact, the number of alluvial gold-mining companies in Russia has shrunk by one third since 2003.

Braiko also said he is concerned that no major new gold ventures are planned for this year. "The situation with gold production will not be improved in Russia until the companies working at alluvial gold deposits become really effective," he added. On his initiative, reports Itar-Tass, a group of deputies to the State Duma are now drafting a law to reduce tax rates and social deductions charged to alluvial gold miners.

Russia's new-found power as an energy producer could point the way for the Duma's decision or rather, the Kremlin's decision on Russia's gold mining taxes and deductions. For Russia now has the chance to become the world's biggest oil producer this year, overtaking Saudi Arabia by oil output according to its deputy prime minister Dmitri Medvedev. He was speaking at the World Economic Forum in Davos, Switzerland on Saturday.

Ignore the delusions of petro-grandeur for a moment. Medvedev also noted that Russia's economy has grown by 60% after deflating for growth in consumer prices since 2000, making it "one of the most rapidly growing markets."

"I would like to mention specially a very important fact,' he went on. 'Russia has turned from a debtor country into a creditor country. We no longer need official credits. Neither do we insist on the restructuring of [our] debt.'

Russia's former Cold War enemies, meantime, now have more debt priced in more paper money than at any time in history. Looking for signs of inflation in this week's US data would miss the point.

The US public debt now grows by $1.5 billion every day. Private debt has reached more than $8,000 per head of population. Inflation is alive and well, in other words, and driven by an explosion in the supply of credit worldwide it's eating into your savings and investments every day that passes.

But you don't need us or the Fed to tell you that this week.

Adrian Ash is head of research at BullionVault.com, the fastest growing gold bullion service online. Formerly head of editorial at Fleet Street Publications Ltd the UK's leading publishers of investment advice for private investors he is also City correspondent for The Daily Reckoning in London, and a regular contributor to MoneyWeek magazine.