Your editor has been focusing on the perils of deflation now for the past several years. But recently, I have been talking more about the perils of inflation. We have become more aggressive with our inflation hedges in our Model Portfolio, and in our September 2005 monthly letter, we headed up our views with the topic, "Profiting from Inflation while Awaiting the Kondratieff Winter." What gives, Jay? Why this sudden emphasis on inflation, when all you could talk about previously was the threat of the next Great Depression?

To answer that question, all I really have to do is direct your attention to the chart of the Consumer Price Index (CPI) above, as well as a chart of the Producer Price Index (PPI) below. Clearly on both charts, the rate of inflation has recently risen fairly dramatically.

The numbers charted are based on the U.S. Labor Department's calculations. While those folks who crank out these statistics are no doubt very honest and hardworking, their bosses, who are closer to the political process, may not be totally objective in establishing the marching orders of grunt statisticians. No doubt those political motivations, which have an influence on reported inflation (especially consumer inflation, upon which wages and social security benefits are based), are generally understood to grossly understate actual increases in the price of goods and services. Nonetheless, what we see in both the CPI and PPI charts above and below suggests that inflation rates have broken decisively through multi-year levels. The CPI shown above had been contained at a high of 3.5% over the past several years, but now has suddenly broken up to 4.70%.

Even more dramatic has been the skyrocketing rise in the PPI. A glance at the chart on your left shows that we were beginning to experience some mild deflation in late 2001 and through the end of 2002, when producer prices were on average actually deflating by as much as 2.70%. It was during that time that Mr. Bernanke made a speech and wrote a paper titled, "Deflation-Making Sure It Doesn't Happen Here." That was the infamous helicopter speech in which he suggested, if necessary to avoid deflation, helicopters could always drop money over the population to spur spending. Well, what we can see is that Mr. Bernanke's "helicopters" have worked all too well, with the latest year-over-year PPI now at an astoundingly high 7%!

My friend Al Korelin, who, along with Paul Warren, hosts the Korelin Economics Report at www.kereport.com, painted a very accurate picture when he said the economy is precariously balanced on a tightrope. I think that is totally accurate, because policy makers at the Fed are posed with two very significant risks. If they continue to raise rates at the same old slow and measured pace, while continuing To create enormous amounts of new money out of thin air, the inflation rate is likely to accelerate. On the other hand, if the Fed chooses to get tough and put an end to inflation, as Paul Volcker did in 1980 by throwing money growth into reverse, the beginning of Ian Gordon's view of a Kondratieff winter deflationary collapse could well be upon us very, very quickly.

Within the last couple of weeks at Syracuse University, Paul Volcker himself warned of rising inflation in the United States and also about how our excessive consumption (in the range of 6% to7% more than we are producing) will sooner or later lead to major financial problems.

Volcker noted that this kind of irresponsible lifestyle can only continue as long as the world has confidence in the dollar.

Higher Inflation Rates Beget Higher Interest Rates

With U.S. inflation now rising dramatically, higher rates of interest are being demanded by creditors. Most significant among our creditors are foreigners, who, unlike Americans, know how to save. The 30-year T-Bond chart on the prior page suggests many of these folks are starting to sell their long-dated bonds, evidenced by rising rates. Can you blame them? Would you like to lend someone money when, after having done so, you have less purchasing power than before?

Unless interest rates are raised to a level high enough to make their investment in the United States worthwhile after considering the loss of purchasing power caused by rising prices, creditors will continue to sell their U.S. Treasuries and thus drive interest rates higher. In fact I suspect that is exactly what is starting to happen now.

Please, Mr. Bernanke! Not Too Hot.
Not Too Cold. Just the Right Mix.

With long-term interest rates just starting to rise a bit, we have seen a fairly dramatic decline in the homebuilding stocks. Since equity markets are forward looking, this suggests the housing sector could be in for a real contraction if inflation rates remain high and interest rates begin to rise to levels that to normal levels above inflation rather than negative real rates of inflation as we have now.

Again, interest rates must rise to sufficiently high levels to attract foreign capital to fund America's excessive spending habits. Yet, if rates rise too much, I think that is when Ian Gordon's Kondratieff winter winds begin to chill our economy to a standstill. In other words, if the Fed cannot balance its monetary policy perfectly on Al Korelin's tightrope, then we will fall on one side of the rope-the inflationary side, or the other side of the rope-the deflationary side. Either way, we eventually will have to bite the deflationary bullet, because rising inflation rates will, without any doubt, lead to dramatically higher interest rates. And higher rates will inevitably lead to a major recession/depression, given our huge indebtedness.

And so the important question is this. Are the higher interest rates we saw in September a new trend or just an anomaly soon to be forgotten as a non-event? I think what we are seeing is a new, powerful trend in place, caused by energy supply issues and an extremely accommodative monetary policy even as the Fed pussyfoots around with ¼% interest rate increases that leave policy woefully behind the curve.

Not only are year-over-year inflation rates already at multi-year highs, there are reasons to believe inflation rates may actually be ready to accelerate. And of course even higher inflation rates imply even higher interest rates. Note above for example, that the PPI is now around 7%, compared to "just" 4.7% in the CPI. That suggests producer prices have not yet made their way through to the CPI. Moreover, the latest wage figures imply that, for the first time in a long time, we are starting to see some significant wage inflation. All of these factors are suggesting that the U.S. and its financial markets are starting to experience some very significant inflation problems for the first time since Mr. Volcker devastated economic demand by raising interest rates to unbelievably high levels. I remember this vividly, because my first mortgage back in 1982 carried a 17.5% rate.

I don't think interest rates will get that high this time around simply because I do not think the U.S. economy could survive those high rates now, for a host of reasons having to do with the enormous amount of debt we now have relative to GDP as well as the declining economic status of our nation.

But the problem the Fed faces is that it must balance monetary and interest rate policy perfectly, lest it fall off one side or the other of the tightrope upon which it is balanced. One little mistake in either direction could spell huge problems for our markets. Slip off one side of the tightrope and fall into a galloping inflation that will ultimately result in deflation. Or bite the bullet now with a Volckeresque dramatic rise in interest rates and send us into the K-winter sooner rather than later. More than ever, when it comes to allocations in our Model Portfolio, we need to be able to determine which of the monetary devils pose the most serious threat next. If inflation, we want to weight our allocations toward commodities including energy stocks and base metal plays. If deflation, then we weight our portfolio heavily toward cash and gold.

November 10, 2005

Jay Taylor, Editor of J Taylor's Gold & Technology Stocks
www.miningstocks.com