The Next Word On Gary North's Claim That The Fed Is Deflating
Steve Saville
In our
31st March commentary we discussed the errors we saw in Gary North's
opinion that the Fed is deflating. Strangely, Mr. North took this as a personal
attack and launched a personal counter-attack at http://www.garynorth.com/public/3328.cfm.
We didn't make any personal comments about Mr. North's analytical ability in
our previous report -- we took issue with one aspect of his analysis, not with
his overall analytical ability -- and won't do so now. In other words, we
aren't going to respond in kind to the above-linked article. Instead, we'll
simply point out some of the salient differences between his outlook and our
outlook. Before we get started, though, the point we took issue with -- and
rebutted -- in our previous report was his claim that the Fed was deflating.
This needs to be kept firmly in mind, because in his attempt to rebut our rebuttal
Mr. North makes liberal use of rhetoric in an apparent attempt to shift the
reader's focus to other areas. To set the record straight we will touch on some
of these other areas in the following discussion while trying to stay as close
as possible to the original topic.
The first thing we'll note is that when we use the term "inflation"
we mean an increase in the total supply of money. Therefore, if the total
supply of money is increasing then, as per the definition we use, inflation is
occurring. There is a reasonable difference of opinion as to which monetary
aggregate best represents the inflation (money-supply growth) rate, but for the
reasons outlined in our earlier discussion on this topic and briefly addressed
below we are certain that M1 is amongst the poorest representatives of the true
inflation rate.
Secondly, Mr. North appears to believe that the CPI is a good indicator of the
effects of inflation (what he calls "price inflation")*. Our view,
however, is that the CPI is a number concocted by the government primarily for
the purpose of managing inflation expectations and these days bears little
resemblance to the loss of purchasing power that is actually occurring within
the economy. Evidence supporting our view is provided by the large difference
between the pre-Clinton CPI and the current version of the CPI as illustrated
by John Williams at http://www.shadowstats.com/.
Thirdly, Mr. North cites the recent downturn in the gold price as evidence that
his deflation claim was 'on the mark', but a sharp bull-market correction in
gold does not constitute evidence that the Fed is deflating. For one thing, we
know that the Fed is NOT causing deflation since the total supply of money has
been rising. For another thing, there is no consistent relationship between
short-term movements in the gold price and changes in either narrow or broad
money supply. For example, M1 is roughly the same today as it was three years
ago, yet the gold price has more than doubled during the intervening period.
Fourthly and as explained in our previous piece, M1 has generally been a poor
indicator of monetary conditions since the early 1990s thanks to the regulatory
changes that were implemented at that time. M1 now tends to remain flat for
many years at a time, as it has been since the final quarter of 2004.
Finally, we all know that markets don't move up or down for extended periods in
straight lines. Even when the fundamentals decisively point one way, a market
will often move in the opposite direction for a while before returning to its
underlying trend. Prior to the start of gold's correction there were, according
to Market Vane, more than 10 gold bulls in the speculating community for every
gold bear, and whenever sentiment becomes that lopsidedly optimistic the risk
of a sharp pullback will always be high.
Of course, it wasn't just the gold market that was at risk of a sharp
correction due to extremely lopsided sentiment. In our 5th March commentary,
under the heading "Commodity Reversal Imminent", we wrote that "the
Continuous Commodity Index (CCI) was embroiled in an upside blow-off that
should lead to an intermediate-term peak within the coming few weeks (probably
by mid March and almost certainly by early April). Food commodities have been
leading the charge higher and, as a result, will probably experience the
largest price declines once a trend reversal occurs.
Bull markets are fueled by the conversion of sceptics (bears) to believers
(bulls), which is why they tend to end, or at least experience substantial
corrections, shortly after the proportion of bearish market participants has
fallen to a low percentage. According to Market Vane, earlier this week only 2%
of traders were bearish on soybean oil, only 3% of traders were bearish on
oats, only 4% of traders were bearish on soybeans, only 6% of traders were
bearish on cocoa, and only 10% of traders were bearish on corn. The world of
precious metals is almost as one-sided with only 5% and 7%, respectively, of
traders bearish on gold and silver. The other side of the coin is that about
80% of traders are bearish on the US$."
Further to the above, the catalyst for the recent gold correction was most
definitely NOT a Fed-driven tightening of monetary conditions (how could it
have been when such a tightening never occurred?), but was, instead, largely a
consequence of the extreme bullish sentiment that led to the build-up of a
massive speculative long position in gold futures. Other factors that played
significant roles were: a) the stabilisation and subsequent rebounding of the
broad stock market (as anticipated in our commentaries), b) the temporary
narrowing of credit spreads, and c) a rebound in the US$ relative to the euro.
*"Price inflation" is
a term we always avoid because it strictly means more prices, not higher
prices, and confuses the cause (inflation) with ONE of the effects (higher
prices)
April
4, 2008
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