Late last year, October 2009 to be exact, we wrote a post about inflation or deflation in 2010. After significant feedback, requests, and time, I thought it would be appropriate to revisit the article and discussion on whether or not 2010 is heading towards inflation or deflation. First let’s get everyone up to speed:

What is Inflation?

Inflation is defined as a general and progressive increase in prices. Pretty simple, and I’m sure we’re all pretty familiar with this common definition. If you’ve ever heard your parents or grandparents complain (or fantasize) about how prices for a  movie were just 25 cents and you could buy a home in the 50’s for less than $15,000 you’re probably familiar with inflation (although in some areas home prices have insanely dropped to such a low).

Inflation though is a funny thing.

WHY DO THINGS COST MORE? Is it because they are now higher quality? Because they use more advanced, expensive materials? Probably not. The truth is over time, the costs of goods SHOULD go down. As we (humans) become more efficient at mining, assembling, and creating, the costs of goods shouldn’t go up.

The truth is, inflation is really the weakening of a national currency. A dollar doesn’t buy as much as it used to in the 50’s. Check out this awesome chart I found courtesy of Campaign for Liberty:

Did I just blow your mind?! I bet I did. You see how, over time, the purchasing power of the dollar has decreased. Or put another way (and shown on an inverted graph) inflation has increased over time. Never mind the correlation of the steep drops to us leaving the Gold Standard. That’s a whole other post.

What is Deflation?

Deflation is defined as the contraction of economic activity (for example spending within the U.S.) resulting in a decline of prices. It’s a decline in prices. As our economic engines slow there is less need for goods/services (or less desire for consumption) so prices inevitably fall. This is definitely been evidenced, in some small ways, over the last 1.5 years (since the crash of the stock market and turning point of the economy).

As a quick side note… remember all the hulabalu over whether or not the U.S. economy was in a recession or not? Pundits all over CNBC and other networks were going back and forth and no one wanted to admit it. Those were the days.

Back to deflation. If you’ve purchased a car recently, home, etc. you’ve no doubtedly noticed that prices are lower than they once were (circa 2004 – 2008). I purchased a car about 6 months ago that I never could have afforded a few years ago, but because of dealers’ huge inventories I was able to get my dream car. Same with houses. The market is literally flooded with homes, both those that were built and never purchased as well as  ”older” homes whose owner’s were in financial distress and either need to sell, or have been forced into foreclosure. Prices have come down.

But the purchasing power of the dollar is down.

So the question I have is…

Will 2010 signify both deflation and inflation?

Prices, relative to the purchasing power of the dollar may go up (as the dollar falls), ie inflation, but since there is less money shuffling, less purchases being  made, the general prices of goods and services in the U.S. may also fall.

In this case inflation will cancel out deflation – and the average U.S. consumer will see no or nearly no differences. BUT and it’s a big BUT if I may say so, the U.S. economy and the dollar relative to other countries’ economy and currency will stagnate and look stale, dated, and impoverished. Let’s face it, with such little collective savings, and such enormous debt, we are in trouble. So, where deflation may save us for awhile, our engine can only grind to a slow murmur. We will always need to consume the essentials – food, water, housing.

And when that happens should inflation continue, as it should given our ballooning national debt and deficit, we may be spending $100’s of dollars for a cup of coffee.

American families are now battling a 2.7% inflation rate this year.

Inflation jumped 1.6% just this week. Have you bought gold yet?

This was the biggest drop since 1990. The administration is saying the consumer spender will lead us out of the recession.

With 15.3 million unemployed, the jobless consumer spender? With a 2.7 percent rise in the consumer price index? With energy prices during this cold winter shooting up 18.2% – the biggest rise since ‘79?

Though as Theresa Bryan told the Assoicated Press when they asked her how she had been affected by inflaction, “”I don’t notice anything because I’m so broke.”

From the New York Times

The New York Times is doing a series of articles on the ever growing US national debt. Currently, the debt sits at over $12 trillion. By 2019, it will take $700 billion per year just to pay to the interest! From the Times

In concrete terms, an additional $500 billion a year in interest expense would total more than the combined federal budgets this year for education, energy, homeland security and the wars in Iraq and Afghanistan.

With interest rates near zero and constant borrowing, the government is setting itself up just like many sub-prime mortgage owners. When the rates flip, we will find ourselves in an avalanche of debt. The most pressing issue to resolve will be the short term debt, expressed in the above graphic. The only way to solve it is by more debt! What are the options the government has?

• Raise taxes and reduce the budget
• Inflation
• Default
• Miraculous economic growth

The only pretty way out is through growth, which is highly unlikely, considering that this recession was declared “over” when the unemployment rate is in double digits.  How can we grow when no one has a job? In terms of preparing for the other options, your best “economic disaster kit” is full of precious metals. Buy gold and you will protect yourself from inflation, deflation, or a government default. The US government has little choice but to continue through this nighmare currency crisis but that’s no reason you need to lose everything in the process.

A few years ago Warren Buffet wrote a parable about two islands, one called Thriftville, one called Squanderville for Fortune magazine to explain trade balances. He makes a great point in this video about the US’s potential to continue borrowing. Our country has  great reputation and has been able to borrow for some time, but eventually the good will can run out. In May of this year, Buffet told shareholders to expect “plenty of inflation.” As we love to point out, gold is the best way to keep your “cash” when inflation rears its ugly head.

The House Financial Services Committee has approved Ron Paul’s amendment that could give Congress sweeping oversight into the operations and policies of the Federal Reserve. Officials from the Fed have opposed the measure, under the guise that “it would undermine the central bank’s political independence and gravely threaten its credibility as a bulwark against inflation,” the New York Times reports.

Hmm, a bulwark against inflation?

Dictionary.com defines a bulwark as follows

Take a look at this chart and decide for yourself what a “bulwark against inflation” the Fed has been.

Wouldn’t you like a little transparency and accountability for the Fed? What I personally would have really liked is to have bought gold in 1900!

Merrill Lynch released the report of their monthly survey of fund managers this week and it’s no surprise they are hedging their bets with commodities like gold and silver. Of the managers surveyed, a net 25% have overweight positions in commodities. In the month of October, only 11% did. This increase gives more strength to the current commodities bull run.

The decision to move so far into gold and other commodities is likely due to inflation fears. 47% of respondents expect inflation to rise within 12 months on a global scale.

Chief equity strategist Michael Hartnett says

Investors see inflation as a greater risk than deflation and are hedging that risk with overweight positions in emerging markets and commodities, and an underweight position in the U.S. dollar.

Dr. Marc Faber, who predicted the 1987 stock market crash and saved his clients, has made a statement the US stock holders will find depressing.

Stock price movements become extremely volatile and erratic in countries with a depreciating currency. In the long run, the depreciation of the currency will usually more than eliminate the gains in local currency terms. So, whereas in 2007 both the Dow Jones and the S&P 500 exceeded their previous highs reached in 2000 in US dollar terms, these indices failed to make new highs in Euro terms.

By examining the gains in both dollars and euros, it appears the outstanding stock market rebound may be little more than evidence of stealth inflation. Companies aren’t making more dollars, it just takes more dollars to buy a piece of one because our purchasing power has decreased. Buy gold and avoid the next market fallout.

Chinese officials have warned that the US Federal Reserve is encouraging “speculative investments” and placing the global economy at further risk through its loose monetary policy. The chief banking regulator of China, Liu Mingkang has identified a “huge carry trade” with US dollars that is having a “massive impact on global asset prices.”

He’s right. The Fed is hoping to stimulate some recovery to gain more jobs by keeping interest rates low. However, all they are succeeding at doing is weakening the dollar further which is resulting in a carry trade. Investors are borrowing cheap dollars and investing it in higher yielding currencies. A carry trade can have dangerous repercussions, just look at Iceland. That was one of the main contributing factors to the economic collapse of the country, which nearly resulted in a national declaration of bankruptcy. As it is, the nation’s citizens had to deal with rampant inflation (hopefully some were prudent enough to buy gold) and are still mired in a severe recession.

Hopefully, our leaders will wise up and avoid history repeating itself instead of continuing their current actions which are “boosting speculative investment in stock and property markets and will pose new, real and insurmountable risks to the global recovery and particularly to the recovery in emerging markets.”

One fact this is not being given much fanfare in all the news stories and press releases is that India did not buy gold from the IMF with dollars. Instead, they used SDRs, otherwise known as special drawing rights currency. SDRs are made up of pounds, euros, dollars and yen. So what does this mean?

It could mean that the IMF didn’t want billions of US dollars. The IMF sold their gold for humanitarian reasons, to increase their lending capacities to developing nations. Maybe they didn’t want to be on the wrong end of the weak dollar and requested that the trade occur in this way.

Or it could mean that India was being kind to the US and didn’t want to appear like it was dumping billions of dollars (when, essentially, that is exactly what India was doing). This is what analysts at BNP Paribas believe, “By using SDRs, the Reserve Bank of India left the impression that it does not like paper currencies in general, suggesting that other major Western currencies were not seen as any better than the USD.”

Either way, the greenback is losing friends.

I absolutely LOVE GOLD

One blogger recently reported on a friend’s breakfast meeting with John Paulson, the multi-billionaire (or multi-bullionaire, as you will soon learn) hedge fund manager. They talked about the Fed’s massive money injection and the coming inflation. And where is John Paulson, #33 on the Forbes 400 list of wealthy Americans, reportedly putting all of his $4.3 billion? If you guessed gold – you’re right!

Paulson believes that Bernanke’s stimulus efforts were the only way to avert another Great Depression…but it won’t be without consequences! The US Monetary Base was increased by around 120%, so more than twice the amount of money is in circulation than there was a little over a year ago. And while we are on the lookout for inflation signs, which have been popping up gradually the last couple months, a cup of coffee is still about the price it was a year ago and hasn’t increase 120%. Why is that?

Because, as anyone trying to buy a house right now, or anyone who’s credit cards have been cutoff without warning and little cause can tell you, the bank’s aren’t lending the money yet. They are sitting on it, watching the news like hawks. So the number of times a dollar is used, “the velocity of money” as its called by economists, has actually decreased, due to the credit crisis restricting people’s funds, lowered consumer confidence, and high unemployment (no paycheck means no shopping sprees). But the velocity of money will increase, it can’t stagnate forever, and that is when we are set to experience double digit inflation.

Paulson cited the Fed’s policies in the ‘70s. They increased the money supply by about 13%, and then within one to two years inflation was up 12%. The massive money printing we have experienced will bring on inflation; it’s just a matter of time for the numbers to catch up with each other. So, if you invested in a 12 months CD over at ING Direct, you would give you about a 1.75% return at the time of this blog post. If in the course of the following year12% inflation kicked in, you would actually lose 10.25% of your money!

I know, I know, a CD is supposed to be a conservative investment to store and protect your wealth. Where can you put your money if all you are trying to do is protect it? Reportedly, Paulson has invested 100% of his worth into a gold option of his own firm’s hedge fund. They offer an option that allows you to invest in the fund using physical gold. A dollar investment must first be converted to a gold investment and that value is invested in the fund which has a number of different asset classes including gold mining stocks. When leaving the fund, you receive gold instead of cash, based off of the day’s spot price of gold bullion. Paulson is predicting a run on gold once inflation kicks in and people try to find some safe hedge for their wealth. One interesting statistic he cites is that all the world’s investible assets total 200 trillion dollars, and gold only makes up 800 billion dollars worth. Simple supply and demand will tell you that we could see gold performing this well for quite a few years to come.