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Gold, inflation & deflation

Does the bull market in gold signal inflation or deflation...?

INFLATION or deflation...? Analysts and economists are split over this issue.

   According to some market observers (including me), we are living in a highly inflationary environment. After all, money supply growth is extremely strong in most countries – and this represents explosive inflation.

   The other camp argues that since prices of some consumer goods are either stable or falling, we must be witnessing genuine price deflation. In my view, these "deflationists" miss the point. Falling prices in consumer goods, due to improvements in technology or the relocation of manufacturing to relatively inexpensive developing nations, have nothing to do with deflation and everything to do instead with economic development.

   In fact, I would argue that in the current environment – of technological advances, rising productivity, free trade and cheap labor – prices should indeed be declining. After all, this is the whole point of genuine economic progress!

   In an ideal world where a stable monetary base represents zero monetary inflation, prices of almost all things – with a few exceptions – would be in decline. That would signal real economic progress, as people's savings would buy them more goods with every passing year.

   But in our far from ideal world, the factor that stops this occurring remains monetary inflation. Due to central-bank sponsored inflation of the money supply, the prices of assets – whose supply is relatively limited when compared to money – are going through the roof. And as a result of this ongoing inflation, even basic commodities critical for human survival have become very expensive. Hence they're now scarce for the average person.

   So next time when someone tells you we're witnessing deflation, tell them to look no further than the escalating cost of housing, energy, food, education and medical care.

   Finally, if we were indeed witnessing genuine deflation (meaning a contraction in the money supply), all asset prices would be declining, rather than flirting with multi-year highs!

Precious metals: We are in a primary bull market currently undergoing a healthy medium-term correction. Everything else is "noise". Such corrections are normal and serve the purpose of shaking out the latecomers and the weak hands. More importantly, such periods of weakness give us the ideal opportunity to increase our positions.

   I am not sure about you, but I always prefer to buy assets when the sentiment is negative and there is widespread fear amongst the investing public. Furthermore, I never purchase anything after a big rally. This is the reason why despite the brutal sell-off in commodities over the past several months, our managed accounts have held up reasonably well.

   I have no doubt in my mind that both gold and silver will appreciate considerably over the coming years. Here are the reasons why:

  • Terminally-ill US Dollar
  • Rampant monetary inflation equals debasement of currencies
  • Record-high US trade and current-account deficits
  • Major top in the US bond-market and rising interest-rates (which will hurt housing)
  • Sky-high debt levels in developed nations; only option is to inflate the currencies
  • Rising geo-political tensions and increasing resource wars
  • A major bull-market in crude oil due to rising demand and tight supplies
  • Gold and silver are inexpensive in real-terms (inflation-adjusted basis)
  • Extremely cheap in comparison to financial assets (stocks and bonds)

   As I've explained in previous reports, I do not expect gold and silver to surpass their May 2006 highs in the near future. I am of the opinion that both gold and silver are likely to decline into the summer months before embarking on a huge rally towards the end of this year. This action will shake out more weak hands and set the stage for a big advance.

   However, if we do get a major conflict in Iran, you will be really glad that you own precious metals.

   At present, Asian central banks hold a miniscule 1.5% of their total reserves in gold. You can imagine what will happen to the price of gold when Asian countries start diversifying into the yellow metal.

   Recently, China announced that it plans to invest $200 billion of its $1 trillion reserves in strategic assets. So this move out of "paper" is already underway.

   Since the commencement of this bull market, precious metals mining shares have provided a leverage of 300% compared to physical bullion. However, over the past few months, physical gold bullion has outperformed the mining shares. These changes in relative strength are normal and I would advise you to utilize any near-term weakness in mining stocks and invest heavily.

Puru Saxena is the editor and publisher of Money Matters, an economic and financial publication run from Hong Kong. He is a regular guest on CNN, Bloomberg, CNBC, RTHK, NDTV and TVB Pearl, as well as featured writer for the Hong Kong Economic Times, South China Morning Post, Benchmark Magazine, and The Daily Reckoning.

See the full archive of Puru Saxena articles.

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

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