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Gold vs. Mervyn King's "Queasing"

How to defend against central bankers defending against their worst nightmare...

A PROLONGED CLIMATE of deflation is a central banker's worst nightmare, writes Gary Dorsch in his Global Money Trends.

Deflation tends to deter consumers from spending until prices become even cheaper, and there is a risk that deflation could become so deeply embedded in consumer psychology, it thus leads to a prolonged period of falling prices and chronically weak company profits.

Deflation, or falling prices over a long period of time, increases the cost of servicing debt as cash inflows are squeezed. Matters are made worse by falling wages and job losses, which can led to widespread defaults on auto and credit card loans. And although the UK economy has been spared the trials of deflation since 1947, the Bank of England is worried that British households with high debts could fall prey to the "debt-deflation" trap this year.

Britain is a nation of borrowers rather than savers, and it was a combination of falling prices and soaring debt burdens that plagued the US economy in the 1930s. Britain's total personal debt – the amount owed on mortgages, loans and credit cards – stands at £1.46 trillion, up 165% since 1997. Each household now owes an average of about £60,000.

Thus the Bank of England's monetary policy going forward is expected to be geared towards combating the scourge of deflation. It will attempt an aggressive inflation to reverse it.

Alongside a half-point rate-cut to 0.50% on March 5th, the Bank of England also unveiled its nuclear arsenal, aiming to purchase £100 billion of British gilts, and £50 billion earmarked to buy corporate bonds and commercial paper. Some £75 billion will be disbursed over the next three months.

Bank of England chief Mervyn King commented, "Nothing in life is ever certain. These measures, we think, will work in the long run. I can't be sure how long it will take."

Put another way, "We are now towards the end of what is pretty clearly going to be a first quarter in which national output falls very sharply," said Bank of England member Kate Barker on March 13th. So "I strongly support the move to Quantitative Easing, and once it became necessary, it was important to act in a decisive manner.

"To gauge the effect of the purchases, I will be looking for a flatter gilt yield curve, narrower corporate bond spreads, and other positive effects on a range of assets. The bank may need to reverse these gilt purchases quickly, once they have their effect."

The Bank of England's shift to what the local papers are now calling "queasing" jolted the British gilt market, driving benchmark 10-year yields below the December lows of 3.0%, and into closer alignment with the slumping Dow Jones Commodity Index, which is hovering some 30% below its level of a year ago, measured in Sterling currency terms.

Although the UK government's official inflation rate remains elevated in positive territory, it's widely expected to turn negative in the months ahead, mirroring the sharp slide in the global commodities markets.

The lessons learned from the Great Depression, as well as from Japan's post-bubble economy in the 1990s, has moved several central bankers into shocking the system with Quantitative Easing, trying to arrest deflationary expectations and reduce the real burden of debt.

The Bank of England has moved boldly, aiming to resurrect the devil of inflation. And whereas the Japanese spent around 5% of their GDP on QE – otherwise known as printing money to buy government bonds – the BoE has already committed to spending just over 10% of GDP.

This comes at a time when the UK's broad M4 money supply is already expanding at a record 18.8% annualized clip. It could soon rival the growth rates seen in third world countries.

But with a record two million Britons signing on for unemployment benefit last month, the BoE has no interest in defending the principles of sound money.

"Most of us come from the generation that grew up believing that mass unemployment and world recession were things of the past, relevant to the history books but not the textbooks," declared Bank of England chief Mervyn King on March 17th.

"That assumption is under threat," he warned. Hence the ongoing surge in the quantity of Pounds in the world, and the attack on their value.

GARY DORSCH is editor of the Global Money Trends newsletter. He worked as chief financial futures analyst for three clearing firms on the trading floor of the Chicago Mercantile Exchange before moving to the US and foreign equities trading desk of Charles Schwab and Co.

There he traded across 45 different exchanges, including Australia, Canada, Japan, Hong Kong, the Eurozone, London, Toronto, South Africa, Mexico and New Zealand. With extensive experience of forex, US high grade and corporate junk bonds, foreign government bonds, gold stocks, ADRs, a wide range of US equities and options as well as Canadian oil trusts, he wrote from 2000 to Sept. '05 a weekly newsletter, Foreign Currency Trends, for Charles Schwab's Global Investment department.

See the full archive of Gary Dorsch.


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