What inflationary pressures mean for gold

Does the biggest threat to the world economy come from inflation, or deflation? And which scenario would be best for gold? Find out why gold bugs could profit, whatever happens.

Commentators like Andy Xie of Morgan Stanley (who wrongly beat the drum for a speculative oil price collapse in 2005) think inflation pressures will be a problem for the next few years and that central banks will bruise the markets in an ongoing battle with inflation. We suspect Mr Xie could be as dead wrong here as he was on crude oil.

Why? Because here in this odd twilight of Bretton Woods II, it is possible for inflationary problems to become deflationary ones very quickly.

Much, if not all, still hinges on the American consumer. The gradual withdrawal of consumer spending power is a potentially deflationary force. The housing bubble doesn't have to implode spectacularly for consumer spending to fall sharply. As the cost of mortgage service rises, discretionary income is squeezed. If the average homeowner keeps the house payments intact, but cuts the budget to the bone to do so, we could have a 'stealth' crisis that slips in the back door - and a creeping recession even if home prices flat line, rather than implode.

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If the Federal Reserve is perceived as losing its handle on inflation yet again, gold will benefit, and for the past few years, gold has been seen as an inflationary hedge. But gold's real run may come in the teeth not of inflation, but of deflation. If Bernanke does not come to the consumer's rescue fast enough - and odds are good it is already too late - then deflationary forces could roll in with a heavy weight of debt behind them, leaving the Fed to 'push on a string' (meaning stimulus without effect).

In a scenario in which economic activity falls as the Fed stimulates, the dollar rapidly loses value (due to more and more dollars being pumped into the system) and gold becomes a proxy for stable cash. When deflation reigns, cash is king - and gold is the only cash equivalent not subject to debasement by frantic central bankers.

At this debt-laden hour, the only way for the world to avoid a deflationary endgame is for global central bankers to get together and pull off a massively coordinated reflationary effort...in which case, gold still wins. Either way, inflation or deflation, gold comes out on top. The reason for this is not some magical property bestowed upon gold; it is because the reality of America's Empire of Debt (and Asia and the Middle East's mercantilist participation in its buildup) has brought us to this point. When the debt gets onerous enough, the only choice left is to liquidate, and the ultimate mechanism of liquidation is debasement of the currency. It just becomes a matter of how to go about it, and under what circumstances. Whichever we get, inflation or deflation, gold is the other side of the inevitable debt liquidation trade.

By Justice Litle for The Daily Reckoning. You can read more from Justice and many others at www.dailyreckoning.co.uk

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