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Inflation, Deflation, Stagflation and the Gold Price

Three kinds of 'flation – and what they might mean for the Gold Price...

WE START today with some definitions, writes Julian Phillips of

According to the Oxford Dictionary:

  • Inflation is the general increase of prices and fall in purchasing value of money.
  • Deflation is the reverse or reversal of inflation.
  • Stagflation is a state of inflation without the corresponding increase of demand and employment.

A situation arises where the quantity of money is not as important as how far its circulation reaches. It slowly becomes insufficient to buy the needs and wants of the population at the periphery of the economy. 

 For instance in stagflation, there may be money around but it's not producing the economic flows that it should. This can also be tied to the extent of the circulation and the velocity of money itself. There may be sufficient money around but is becomes locked up in Treasury bonds and not lent into the economy to stimulate economic activity (such is the case now). Asset prices rise in this environment and further make inadequate the money for purchasing such assets. 

Alternatively, the reduction of money can happen in situations, like today, when mortgages are at an all-time low of 3.94%, but through fear of falling house prices (reducing creditworthiness) potential job losses and the consequential need to save for the rainy day, house buying drops off. Every situation produces a reduction in the available supply of money and precipitates liquidity crises. This is from where the major threat to monetary stability comes. In our global world, with its plethora of national currencies, a non-national asset becomes protection against inflation, deflation, and stagflation across the globe.

Gold is both an international asset and international cash. It's the combination of these qualities (and the liquid nature of gold, in the most difficult of situations) that set it apart from paper money and other assets. It's these qualities that will force the monetary system to bring gold back into the global, monetary system in one way or another.

Today in every country across the world, there is inflation – even when a country is in recession. When we hear the reports on inflation changes, we usually hear just one rate affecting the currency zone we live in. In reality there are several types of inflation, each driven by a different set of forces. 

The serious food inflation being suffered by much of the world has reached 70% in some parts of the world. This is a result of demand and supply pressures. The pressures on the poor are the most worrying from this source of inflation. Some households spend a large percentage of their income on food, so such rises have a serious impoverishing impact on their lives. 

In the developed world, where a much smaller percentage of disposable income is spent on food, such inflation is not as pernicious. To the investment world, the differences show the impact on the ability to invest, the shortage of liquidity for citizen's everyday lives. Where it's possible, this type of inflation can be managed by increasing the amount of food grown – so increasing supply and lowering local prices.

Take a look at oil and other energy inflation. The fact that the oil price is easily managed by oil producers makes any inflation from this source manufactured to suit the needs of those people. As the world runs on oil, price rises affect everyone to a greater degree. Oil prices reflect the sum total of global demand. China, where economic growth is bringing the poor (i.e. low oil-utilizing population) into a world where oil takes a growing part of their lives, is seeing rapidly increasing demand. As half the world falls into this category, we foresee demand from that source growing almost exponentially. The developed world may be going through a falling demand phase, but this could fail to lower prices as the emerging world is more than compensating for such falls. 

Worse still, in the majority of cases, oil demand represents a major import to a nation. The foreign exchange needed to pay for this has to come from the income from exports (except in the case of the US, where they have run a trade deficit for several decades through the printing of new money, which is a leading US export). Oil price inflation is of a different nature as it affects profitability of business and therefore the economic performance of nations themselves. Falling oil prices have a stimulatory impact on nations as money rises in oil purchasing power, when oil prices fall. Again, we see an impact on general liquidity.

Oil price inflation is considerably more pernicious, for oil payments represent a draining of money from a nation because oil payments leave the developed world and arrive on the shores of oil producers, sucking wealth out of those oil importing nations. The same happens with cheap imports. Consequently, we're seeing a draining of wealth from the West to the East. The only way to stop this is to lower oil demand and raise the prices of imports (i.e. Protectionism). In today's global economy, this is proving no alternative.

The burden on smoothing out the three liquidity problem makers – inflation, deflation and stagflation — falls upon the shoulders of the country's central bank.

In terms of ensuring price stability, central banks have to balance the needs of their economy with the money supply available to it. Price stability is achieved when they succeed in balancing the two; however, with governments adding to their burdens by passing some of the responsibility for growth and economic stimulation onto them, they find that they're forced to bend the rules of price stability, and often. 

In the present economic climate, with a recession impending or underway, central banks across the developed world have turned to quantitative easing (significantly increasing money supply through money market and Treasury market operations) to increase money supply and overall liquidity to encourage the banks to find it easy to lend and give the economy the liquidity it needs to grow. 

This hasn't worked nearly as well as had been hoped, for the deflationary forces and slowing growth have discouraged bank lending – businesses and consumers have not sought this extra money. As a result, it has found its way into government bonds and bills against central banks using somewhat toxic assets as collateral. 

There are two possible solutions: 

  • The first is to allow the very painful, politically unpopular, recessionary/depressionary forces to shrink the economy, forcing growth in economic activity, to be followed by greater monetary demand from that growth to bring about a growing economy. Today that would not be politically workable.
  • The second is to rapidly increase the money supply to stop any stagflationary or deflationary shrinkage of the economy.

There is an analogy that may be useful to the reader. The human body needs blood to feed and nurture it. The body requires a certain volume of blood, going at a certain speed and circulation to the outer reaches and capillaries of the body. Interfere with these processes and the body loses its health. The Fed is the supplier of money and can to some extent influence the speed at which it travels. When the circulation slows, the Fed can add quantities of money to speed it up (i.e. quantitative easing). By lowering interest rates, it's hoped that the circulation is improved, and the speed at which the money travels regulates the nurturing ability of that money. But it takes government to exercise the body so that it makes its blood system healthy. When government fails to exercise, the blood systems come under pressure.

Today we find central banks in a very difficult position because the additional money supply has simply expanded the volume of money without forcing its circulation to reach consumer levels effectively. It has found its way into unutilized 'pools' – banks and Treasury bonds where it's of little use to the economy overall. So, economic activity continues to shrink alongside dropping demand and employment. 

That's why the Fed, in a cleft stick, issued this statement, 

"The Fed "will continue to closely monitor economic developments and is prepared to take further action as appropriate to promote a stronger economic recovery in a context of price stability." 

Bernanke may not be finished after attempts in August, September to strengthen record monetary stimulus with unconventional tools. The central bank's near-zero benchmark interest rate and $2.3 trillion of housing and government-debt purchases since 2008 have failed to produce self-sustaining growth in the economy and employment. The Fed is scared of deflation; they're more concerned with preventing deflation rather than containing inflation. Deflation destroys businesses and wounds the economy, long-term. Inflation just drops the value of money. 

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JULIAN PHILLIPS – one half of the highly respected team at – began his career in the financial markets back in 1970, when he left the British Army after serving as an Officer in the Light Infantry in Malaya, Mauritius, and Belfast.

First he worked in Timber Management and then joined the London Stock Exchange, qualifying as a member and specializing from the beginning in currencies, gold and the "Dollar Premium". On moving to South Africa, Julian was appointed a macro-economist for the Electricity Supply Commission – guiding currency decisions on the multi-billion foreign Loan Portfolio – before joining Chase Manhattan and the UK Merchant Bank, Hill Samuel, in Johannesburg.

There he specialized in gold, before moving to Capetown, where he established the Fund Management department of the Board of Executors. Julian returned to the "Gold World" over two years ago, contributing his exceptional experience and insights to Global Watch: The Gold Forecaster.

Legal Notice/Disclaimer: This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment. Gold Forecaster/Julian D.W. Phillips have based this document on information obtained from sources they believe to be reliable but which it has not independently verified; they make no guarantee, representation or warranty and accepts no responsibility or liability as to its accuracy or completeness. Expressions of opinion are those of Gold Forecaster/Julian D.W. Phillips only and are subject to change without notice. They assume no warranty, liability or guarantee for the current relevance, correctness or completeness of any information provided within this report and will not be held liable for the consequence of reliance upon any opinion or statement contained herein or any omission. Furthermore, they assume no liability for any direct or indirect loss or damage or, in particular, for lost profit, which you may incur as a result of the use and existence of the information, provided within this report.

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