Before proceeding, it's always a good idea to start by defining the terms used. In the constant inflation/deflation debate, hardly anyone takes the time to properly define the term "inflation." Actually, the word inflation has many different uses and it's hard to figure out sometimes exactly which meaning financial commentators are referring to. For instance, a common fallacy is to assume that inflation means simply an increase in the money supply. But how big of an increase? And more importantly, it must always be remembered that an increase in the money supply only becomes "inflationary" when it supercedes the underlying demand for money. In other words, the Fed could print money all day and it wouldn't necessarily be considered inflationary if there was always a demand for it.

Also, I think it's important to distinguish between broad-based economic inflation and financial sector inflation (i.e., in the equities/commodities markets). Through its securities lending efforts, the Fed can pump the stock market while having no major effect on inflating the monetary base of the general economy. So again, when financial writers talk about inflation what type of inflation are they talking about?

The type of inflation I'm referring to here is broad-based economic inflation, symptoms of which include dramatic increases in consumer retail prices and durable goods prices, a large increase in interest rates, and of course an exponential increases in raw material prices. What we have so far here in the U.S. are rising commodities prices, yet interest rates remains near 45-year lows and retail prices aren't exactly "going through the roof." In fact, some retail goods prices (such as for computers and other high-tech items) are still falling in price. Also worth noting, despite the recent increases in petroleum-based fuel prices, airline ticket prices are falling for the first time in years. This alone shows the paradox that exists in the U.S. economy between inflationary and deflationary forces.

Hyper-inflation won't happen in the U.S. this decade simply because the economic long-wave, known as the Kondratieff Wave, is coming down into its final downward phase. This long-wave pulse is responsible for the major long-term phases of inflation and deflation which our country periodically experiences from decade to decade. In other words, we're still in the "runaway deflation" part of the K-wave. And while the financial system is currently being "inflated" the overall economic climate is still deflationary (although you wouldn't know it just by looking at commodity or stock market prices).

Here's why hyper-inflation cannot happen in the U.S. economy: there are simply too many debts out there with totals in the trillions of dollars. Picture these debts if you will (corporate, private, and federal) as being potholes, or more appropriately, sink holes dotting the landscape. In a place where the land is very flat with no crevices or holes to be found anywhere, a prolonged rainfall will eventually create flooding (i.e., an "inflation" of too much water). But when the land is filled with huge sinkholes and underground caves it becomes extremely difficult for flooding to occur -- even when the rain continues unabated for a long period of time. This is obviously true because the water always has somewhere to go, some hole always waiting to be filled.

Metaphorically speaking, this is exactly the situation the U.S. finds itself in. There are just too many debts waiting to be serviced and any increase in the money supply will go to fulfill those debt obligations. You can't have hyper-inflation when there is the ever-present, countervailing force of deflation weighing against an increase in money supply. And despite the financial asset inflation of the past year, deflationary forces still abound in our economy.

Examples? How about automation and technology, which will always make sure that there will always be a plentiful supply of goods and services to absorb the excesses brought about by inflation. This is something that the Weimar Republic did not have, the ability to create goods on demand with today's high technology. Moreover, we know that improvements in technology continue to grow at an exponential rate, assuring that not only will the market be super-saturated with products to absorb the increase of money, but will also assure that the job market becomes more and more precarious in coming years. The global economy (i.e., international competition among numerous countries, some of which can provide goods and services at pennies on the dollar) is another deflationary force that will keep inflationary pressures in check.

I think people underestimate sometimes just how enormous the U.S. economy really is. The economic system has become so vast and complex that it would take an unparalleled attempt at money pumping in order to create conditions of hyper-inflation. Plus, when you consider the inter-locking ties the U.S. has with other countries through the so-called "global economy" (which wasn't nearly case during the inflationary times of the 1970s), hyper-inflation becomes unthinkable. There will always be a demand for money somewhere and no amount of pumping can ever super-saturate the economy.

Now what about the substantial increase in commodities prices that we've seen since 2001-2002? Undoubtedly the rate of change increase has been large, yet most commodities are still a long way from their previous highs made during the runaway inflationary part of the current K-wave (in the 1970s). And even though some commodities (most notably gold, silver and platinum) will undoubtedly make new all-time highs in coming years, other commodities probably will not exceed the highs made in 1980-81. A perfect example of how runaway commodity prices will always come face-to-face with the deflationary force of the K-wave is found recently in the cattle market. After a dramatic rise in cattle futures prices through most of 2003, cattle prices suddenly collapsed in December, retracing much of its 2003 gain in a matter of days. The fundamental or psychological reasons for this great drop are really inconsequential. The point is that cattle price inflation came face to face with the over-riding deflationary force of the K-wave. I predict we will see this phenomenon of boom and bust, inflation/deflation, repeat itself many times in the next few years. In other words, every time inflation threatens to get out of control in the financial markets, deflationary forces will come to the rescue to prevent hyper-inflation in prices from happening.

Also worth pointing out is that if you do a breakdown of all the different commodity sectors out there you'll note that while some commodities have been rising impressively in the past two years, others are still in the proverbial doldrums and haven't even started rallying yet. Some commodity sectors have become over-extended and will undoubtedly experience "corrections" in coming months while other laggards (such as corn and coffee) will likely begin their bull markets. You can see the balance this would bring since not all commodities and sectors are rising at the same time. This will also offset inflationary pressures.

The K-wave in its present deflationary stage will ultimately keep hyper-inflation from every becoming a reality in the U.S. economy this decade. That's not to say that temporary, localized hyper-inflations cannot exist on some occasions and in some pockets of the economy (or in certain smaller countries). But the point is that they will be a.) temporary, b.) localized, and c.) will ultimately recover before the damage spills over into the broad U.S. economy.

There's an old saying that "the old generals always fight the old wars." The "old generals" operating today still have a vivid recollection of what the 1970s were like with its attending inflationary economy. Since gold prices have been rising these old generals assume that we must be heading into a serious inflationary phase once again, and so they begin to fear it and start screaming "hyper-inflation is coming!" This is a fallacy on their part, as I hope I've demonstrated in this article. They are making a mistake and would soon realize the error of their ways if only they would look at ALL of the indicators (not just gold prices). Most importantly, it should never be forgotten that until the K-wave actually bottoms, there can never be any danger of hyper-inflation in the broad U.S. economy.

January 12, 2004

Clif Droke is the editor of the Durban Deep/XAU Report, a daily forecast and analysis of DROOY, GLG, KGC, XAU, HUI, and GOX written especially for day traders. He is also the author of numerous books on finance and investing, including the top-selling "Moving Averages Simplified." Visit his web site for free samples of his analysis at www.clifdroke.com