Tuesday, October 28, 2008

Why I am scared about the U.S. Dollar despite the current deflation

These two charts from the Federal Reserve website (http://research.stlouisfed.org/fred2/) show why. First, a chart of the nominal amount of "new money" created by the Federal Reserve lately, called the "Adjusted Monetary Base."

Next, to keep the nominal amounts in perspective, a chart that shows the percentage year-over-year change in the adjusted monetary base:

So, what does this mean? It means the Federal Reserve is printing money like mad. Right now, banks are hoarding the money instead of making new loans because banks are nervous to lend in this environment and consumers are either unable or unwilling to make major purchases right now (deflationary activities by these market participants). It is to the point where the Federal Reserve and U.S. Treasury are bypassing the banks and giving money directly to companies and shoring up commercial paper markets directly, trying anything and everything they can think of to ward off a deflationary spiral. Looking at the chart above, the monetary injections by the Fed after 9/11 and in anticipation of "Y2K" (anyone remember that crazy b.s.?) are tiny warm-ups compared to the current situation.

This monetary shitstorm is ultimately highly inflationary, though it will take time to work its way into the system. If everyone has $100 of Monopoly money and then the U.S. government hands out the equivalent of another $100 of Monopoly money per person, prices will double. That's inflation in an oversimplified nutshell. Cash is king during a deflationary period, which we are now in, but exactly how long it will last is difficult to predict precisely. Those who hold U.S. dollars during this period are doing the right thing, but they will need to switch back to other asset classes once this new money printing makes its way into society and the dollar begins to fall again.

This is why I hold physical gold. It will retain its purchasing power during the current deflationary environment (unlike other commodities such as oil) and it will rise in value once the next potentially massive inflationary wave gets underway. Gold does not require a healthy economy to perform as an asset and, in fact, tends to outperform (or at least hold its value) in times of economic trouble. For those who don't know anything about how to buy physical gold, it's time to learn.

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