The dramatic expansion of the Federal Reserve’s monetary base will lead to a huge rise in the money supply. While the transition to rapid money supply growth will not occur overnight, the seeds have been planted for a shocking rise in inflation. We submit that a discussion of inflation seems absurd amidst the deflation scare presently occurring. However, it is important to note that inflation is a monetary phenomenon and the implications of policymakers injecting massive amounts of money into the system through the alphabet soup of bailout programs will have ramifications. It is naive to believe that there are no consequences to these actions. There is no free lunch.
This profound increase in the monetary base is being replicated across the globe and will lead to dramatic increases in the money supply of currencies worldwide. Greater quantities of currency per unit of a nation’s output leads to reduced purchasing power. This debasement of currency will ultimately lead to higher gold prices in all global currencies. Gold and gold mining equities are one of the few hard assets that offer investors liquidity and where the fundamentals have improved due to the massive deflation underway and the central banks’ policy responses to it.
Prior to becoming chairman of the Federal Reserve, Ben Bernanke gave a speech on November 21, 2002, entitled ‘Deflation: Making Sure ‘It’ Doesn’t Happen Here.’ We find certain statements within that speech to have particular relevance to the current series of government responses to the ongoing financial crisis. This view, as expressed by Bernanke below, is at the core of all the current responses that have been introduced to ameliorate the crisis.
Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it.
Deflation poses systemic risks to the banking system at-large as loan collateral values fall. Moreover, and perhaps more importantly, deflation implants in the consumer psyche the belief that prices will be cheaper in the future, and that delaying purchases makes economic sense — a psychology that exacerbates and reinforces the slowdown in economic activity. With this understanding it becomes clear that the Fed must take extraordinary steps to stave off deflation because preventing it ‘remains preferable to having to cure it.’ What that statement means is that fighting deflation is preferred – despite the inflationary implications – when compared to the economic and social costs incurred if deflation is allowed to feed on itself without aggressive policy responses.
Equally, it is clear from Bernanke’s 2002 speech that once monetary action is exhausted we can expect a series of direct injections into the economy. As stated within this speech:
To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets it buys.
We have seen ample evidence of this expansion as we witness the Fed and Treasury purchase all manner of assets from banking institutions to reliquify them in an attempt to improve their balance sheets and their ability to lend. Perhaps the best example of this policy is the Fed’s direct purchase of corporate commercial paper through its Commercial Paper Funding Facility (CPFF), which accumulated $243 billion of commercial paper from non-financial corporations in its first two weeks of operation.
It is our belief that the current market concern over deflation will be replaced by a growing concern over the inflationary impact of this monetary creation. As Bernanke stated within this speech:
If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.
The longer term implications for gold are clear. While Bernanke’s speech was given six years ago it is clear that even then, as a scholar of the Great Depression, he was speculating about the types of actions that would be necessary to arrest a deflationary pulse. As we have stated in the past, a Fed that is concerned with fighting inflation presents a serious headwind for gold while conversely a Fed fighting deflation will lay the groundwork for a higher gold price.