Deflation Risk: Good for Gold
Massive sovereign debt loads, yawning budget deficits and high unemployment in the developed world raise the chances of deflation in 2010. If deflation were to occur, it could be good for gold.
I have written about deflation in the past, but it’s such an important theme that it warrants a revisit. I see it as a key risk to the global economy — a far greater risk than inflation in the near term.
Deflation is especially risky because, once under way, it’s a cycle that’s hard to break. In the U.S., for example, slow economic activity and high joblessness (currently around 10 percent) can drive down prices, which leads people to delay spending because they think prices will keep falling. This further slows economic activity, which leads to more joblessness, and around and around it goes.
The competitive effects of globalization add to the deflation risk. Labor is getting ever cheaper in a worldwide jobs market, and excess global capacity continues to lower production costs.
An article from the Federal Reserve Bank of San Francisco offers an excellent discussion of deflation risk based on studies of the Great Depression and the late 1990s in Japan. According to an analysis detailed in that article, there’s an 85 percent chance of deflation in the U.S. this year.
Governments are keeping capital cheap — interest rates are near zero and will be for a long time. U.S. banks have a lot of money to lend, but we don’t see that happening based on measures of money velocity. And given the enormity of government debt loads, future fiscal and monetary options are limited — not that the White House and Congress won’t be tempted to provide desperation stimulus as the 2010 midterm elections draw closer.
In the face of low or no domestic growth, the U.S. and other countries can be expected to engage in a competitive spiral of currency devaluation to increase exports. This race to the bottom stands to lift gold as investors seek to store their wealth in an asset with tangible value.
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