Much will be revealed this week in the Aussie market, although a lot will probably remain obscure too. Producer price data for the September quarter comes out from the Australian Bureau of Statistics. Inflation anyone? Maybe not in wages. But certainly in raw materials (energy).

And speaking of inflation, the Housing Industry Association will report new homes sales data for September later this week too. What do you reckon it will show? Our prediction: how prices in Australia are outrageous and getting more so with each passing month, as the banks double down on home lending.

You may even see a move in the Aussie gold price this week. It could come if the U.S. dollar pulls itself together for a bit of a rally, as we're expecting. But the other reason Aussie gold may go up is a small item on the front pages of today's Australian Financial Review. "Big Banks gear up to lend again," reports the AFR. Uh oh.

No one's been too terribly worried about consumer price inflation lately, mostly because it's been masked - until recently - by cheaper oil prices. Of course the biggest factor affecting consumer price inflation is the growth in bank credit. The RBA reports on that later this week. But bank lending is the main engine for new money creation in the economy...and new money creation is the main engine for inflation.

"The Big Four banks are keen to lend more aggressively to large businesses as the economy recovers and competition for assets intensifies, in a development that is likely to drive down corporate borrowing costs," Katja Buhrer writes. "The major banks are seeking to take advantage of surplus capital and improving corporate growth prospects."

Hang on! Surplus capital? Just last week we were under the impression that Aussie banks were having to import capital from foreign lenders in order to fuel the housing bubble. Now there's surplus capital? And now the banks are eager to loan it out and build up the asset side of the balance sheet again?

So much for deleveraging in the financial economy! This sounds like re-leveraging. It also sounds like exactly the sort of thing - a fresh new wave of bank lending into the real economy - that could trigger much larger inflation. This is the sort of thing the RBA is trying to prevent by raising rates. But if banks start expanding the asset to capital ratio again, watch out! You could see higher Aussie interest rates AND a higher Aussie gold price.

"West Africa beckons as Aussies go for gold," reports Barry Fitzgerald in today's Brisbane Times. This answers a basic investment question: which Aussie gold producers benefit most from a rising gold price and a strong Aussie dollar? ASX-listed firms with greenfield West African gold assets generally have their costs in U.S. dollars. That's a big advantage over domestic gold producers.

Dan Denning
for The Daily Reckoning Australia

• RBA Rate Cut Does Little to Unlock Credit Market
• Global Credit Shortage is Over According to European Central Bank
• Australian Recession in the Works? Ask the Sharemarket
• Foreign Investment in Australia, How Much is Too Much?
• Banks or BHP?

Two important things happened yesterday, both of which cast a crimson light on things.

First, the Dow dropped again; it has only gone up one of the last 7 days. It went down 203 points. Could be nothing. Could be something big...the beginning of the long awaited 'next leg down' for the bear market...the opening day of a bloody Red October.

Charts of oil, commodities, copper, the dollar, and Treasury bonds tell us the same story. The greed investments are topping out. The fear investments are headed up.

What's a 'greed investment?' It's anything that benefits from an improving outlook for the economy and inflation - oil, commodities, and stocks, mainly.

What's a 'fear investment?' It's something that goes up when people begin to suspect the boom is a phony - namely the dollar and US Treasury bonds.

The dollar is rising. So are Treasuries. Yesterday, 30-year US Treasury bond yields fell below 4% for the first time since April.

And what about gold?

Well, that's the other important thing that happened yesterday. Gold held above $1,000.

So what?

So what?? Well, dear reader, you are in a prickly mood this morning, aren't you?

This is important because gold could go either way. Gold is a refuge in times of fear - especially when people fear inflation or a falling dollar. Gold is also a target of greedy speculators sometimes, even when the going is good. According to a study done by the World Gold Council, you never know what gold will do. That study was a great comfort to us here at The Daily Reckoning; we thought we might have missed something. But no. We may not know what gold will do, but neither does anyone else.

Looking around, we see no sign of consumer price inflation. So gold's recent rise must have been driven by optimistic speculation - along with oil and stocks. Now, when oil and stocks go down... we have to wonder whether gold will go down too. The answer, given yesterday, was what we expected - yes, but not as much.

There's substantial risk in gold as well as stocks. The ultimate low for the Dow should be below 5,000. That is, let's say, about a 50% haircut from current levels. And let's assume that gold does what it did yesterday...let's suppose that it goes down only 40% as much as stocks. That would still be a drop of 50% of 40%, or 20% - to the $800- an-ounce level.

If you would be gravely upset by a drop of that magnitude...you probably shouldn't buy gold at this level. And, of course, you should have sold your stocks already. Stick to cash - and gold, if you're long-term oriented - until this next phase is over.

The economic news was mixed, as usual...with nothing to make us think that our basic outlook is wrong.

On the optimistic, bullish side...consumer spending rose in August. Pending homes sales went up too.

But on the pessimistic, bearish side... "September auto sales plunge," says a Reuters headline. Yes, auto sales drove off a cliff last month - just like we said they would. GM reported a 47% drop.

What happened? The clunkers program was an economic fraud. Like all attempts to boost consumption, it merely shifted sales from the future to the present (now the past). Which is a big reason why August consumer spending looked good too.

But wait a few weeks for the September consumer spending numbers. Especially if the stock market continues to fall... Then we'll find out how sustainable those retail sales numbers really are.

As you know, here at The Daily Reckoning headquarters...in the building with the gold balls on the south side of the Thames...we are often accused of 'pessimism.' We deny it. We're optimistic about the fate of mankind. But we are pessimistic about many of his current pretensions - such as health food, enlightened central banking, contemporary art, mass education, global climate control and progressive democratic government.

But maybe we are wrong to be optimists. Pessimists always have the last laugh - when the optimists die. "I told you so," they say, under their last breath.

Bill Bonner
for The Daily Reckoning Australia

• Is Gold Going Up Because People Fear Inflation?
• Biggest Factor Affecting Consumer Price Inflation is Growth in Bank Credit
• Abandoned Shopping Malls to Follow Abandoned Houses
• China Stepping Up Purchases of U.S. Treasury Debt
• September is the Best Month for Gold

Yesterday, both the Bank of England and the European Central Bank announced moves to boost the economy. They're both falling in line behind Mr. Bernanke, who is "pulling out all the stops" in order to avoid a deep depression. Both the BoE and the ECB are going to take up forms of QE - quantitative easing - in which the banks buy government debt directly.

Don't try QE at home, dear reader; you'll be arrested for counterfeiting. QE so closely resembles old-fashioned printing press money that you couldn't tell them apart in a police line up. Both are ways to increase the supply of money...which, according to theory, leads to consumer price inflation.

The Dow fell 102 points yesterday too. The bear market rally has gone on for nearly 9 weeks. It's probably ready for a rest...and maybe a pullback. We doubt it's over though. There is still far too much money and far too many suckers who have not been pulled back into the stock market. The next leg down of this bear market will have to wait - most likely.

Another ominous thing that happened yesterday was that bond yields increased. The yield on the 10-year Treasury note - at 3.3% - is more than a full percent above its low. The yield on the 30-year bond is at 4.26%.

These yields are still very low. But they seem to be moving higher. They are ominous because at some point in the future we expect all Hell to break loose in the bond market. The slippage we're seeing now in bond prices (when prices go down, yields go up) may or may not be an early warning.

But we probably have a few new readers of The Daily Reckoning...let us backtrack in order to bring them into the picture.

We begin by going back half a century. America emerged the world's biggest, strongest, most innovative and dynamic economy after WWII. Then, it went from strength to strength...to weakness. Gradually, Americans turned their attention away from production and towards consumption. And gradually, America's most profitable businesses shifted from making things to financing them. That's why GM created GMAC...and why GE staked its future on GE Finance. And it's why the center of American economic power moved from the manufacturing hinterlands of Detroit and Cleveland...to the financial centers on the coast...notably the big one in Lower Manhattan.

The financial sector boomed by supplying credit. Americans borrowed. And so, their debt increased. From being the world's leading creditors in the '50s and '60s...they became the world's leading debtors in the '80s and '90s. Gradually, the consumer economy required more and more debt to produce an extra unit of output. Debtors had to borrow not only to buy...but also to pay back, or pay the interest on, previous borrowings.

In the Eisenhower years, it took only an extra $1.50 or so of debt to spur an extra dollar's worth of GDP. By the end of the century, the cost had risen to over $4...and then to $6 a few years later. Total debt, which had been about 150% of GDP before Ronald Reagan took office, shot up to 370% in the final years of G.W. Bush.

By the late '90s and early 21st century, the American economy had entered the Bubble Epoque. The financial industry - aided and abetted by the Fed - was providing so much 'liquidity' it was causing asset prices to bubble up everywhere. Of course, bubbles always blow up - without exception. And when the dot.com bubble exploded in 2000, at first, we thought that was the end of the Bubble Era. Little did we realize, the biggest bubbles were still to come. Then came the bubbles in housing, art, emerging markets, oil, and commodities. All blew up. But the biggest bubble of all - the bubble in credit - blew up too, bringing the Bubble Epoque to a close. Capitalism giveth. Capitalism taketh away. The process of what Schumpeter called "creative destruction" continues.

We are now in the post-bubble era. The financial industry has been bombed out. It can no longer create bubbles. Governments all over the world are propping up the walls...and shoring up the foundations. But the Bubble Epoque can't be revived.

Is that the end of the story? Not at all. The feds' efforts to stop the progress of capitalism will have some spectacular consequences. The fireworks will start when the bond market cracks...sending yields through the roof. And that's all we have to say about it today...stay tuned.

Bill Bonner
for The Daily Reckoning Australia

• Between What Bond Investors Stand to Gain in Yield and What They Stand to Lose from Inflation
• Trends in the Post-Bubble Era
• La Bubble Epoque
• Investors Think Things Will Return to the Way They Were in the Bubble Epoque
• Finding Assets that Out Run Inflation as Bond Yields Move Up

We don't know. But yesterday, we promised the crowd, here at the Investment Symposium, that we would have some answers by Friday. Today, we listened to other speakers...hoping something would come up.

What does it all mean? How come oil is backing off? Why are banking stocks going up? How can the United States get out of its debt trap?

And the 'civil war' between inflation and deflation? How will it end? With a bang of hyper-inflation? Or a whimper of falling prices, bankruptcies and recession?

The best we've been able to come up with so far is that - like any civil war - the civilians are getting killed. They're ambushed by higher consumer prices one day...and bushwhacked by falling asset prices the next. Living standards are falling back down to levels not seen in 40 years.

Many times, we've remarked that wages in the United States have not gone up in a very long time. The latest figures on the subject show no real increase since 1968. Since then, every penny of hourly pay increase has been matched by a cent of consumer price inflation.

Only the rich made out well, we were told. They owned assets. And asset prices have soared. But if you quote stock prices...or housing prices...in terms of the number of gallons of gasoline they will buy, you find that even "the rich" aren't as rich as they think they are. The Dow would get you about 2,200 gallons of gas in 1968. Today, at $4.10 a gallon, the Dow is equal to about 2,200 gallons. ld get you about 2,200 gallons of gas in 1968. Today, at $4.10 a gallon, the Dow is equal to about 2,200 gallons.

Of course, in real terms, the Dow came down after '68. It will probably do the same now.

"Well, you don't seem to be very depressed about it," said a local reporter, doing an interview. "In fact, you seem to be in a good mood."

"Why should I be in a bad mood?" we replied. "Most people are no better off than they were when I was 19 years old. Clearly, something isn't working right. If people are going to get richer, they're going to have to do things differently - such as stop trying to spend their way to wealth. A consumer economy doesn't work. It never worked. Kurt Richebächer was right about it all along, RIP. The only way to reliably become wealthier is the old fashioned way - you have to spend less than you earn. I know this may come as a shock to your viewers, but it's true. I urge them to try it: spend less than you earn. Then, you'll have more money. It's like magic...or something...

"Besides, I'm in a good mood because everything is happening as it should. When people spend too much money...when speculators gamble too recklessly...when the government gives out too much cash and credit - there have to be consequences. A free market is not a system designed to give people a free lunch. It's designed to make them better people - by rewarding them when they do the right thing and punishing them when they do the wrong thing. For the last 20 years - at least - people have been doing things that the old economists would have regarded as 'moral failings.' That is, they've been spending more than they make...for example. Now, they've being punished. They're being re-educated. And they're going to end up poorer...but wiser.

"Frankly, we'd rather be dumber and richer, but the markets don't give you that choice. They separate fools from their money. That's what they're doing now. So, what's to be unhappy about?"

Pity the poor fellow with the big suburban house...far from civilized life...and a big mortgage, and a big, gas-gourmand vehicle to get him around. He's got to learn. He's got to downsize...to cutback...to spend less money.

But even this fellow will be better off for it. He'll be able to save some money...build some wealth...achieve great independence - rather than being a slave to his SUV, his house, his mortgage company, and his highway.

It is a miserable way to live. He's living in a "cartoon," said James Kunstler in his speech on Wednesday morning. Then showing a photo: "It's a house with no windows on one side. That's not a real house; it's a cartoon house. And look at the porch. It's 17 inches wide."

He might have pointed to the shutters too. The typical suburban house has no real shutters. It has cartoon shutters, made of plastic and bolted to the wall. You can't use them to keep out the sun or the cold. They're just there so the owner can pretend he has a house with shutters.

Mr. Kunstler is a critic of the suburbs. You get the impression that he's happy to see $4 gasoline - it means the "project of suburbia is over," he says. "One and a half to three trillion dollars worth of capital - lost," he continues, referring to the money spent building out suburbs that, at $4 gasoline, serve no useful function. But good riddance.

And so you see, dear reader, we're all going to be better off. When this cartoon period is behind us - with its phony houses, its phony profits, its phony progress, and its phony GDP growth - people can begin saving again...and maybe their wages will even begin to go up again.

*** "But wait," asked our interviewer, "if the average consumer cuts back, won't that make the situation worse?"

"Of course it will seem to," was our retort. "When the going was good, he spent money he didn't have on things he didn't need. Now, the tables have been turned against him. Now he won't spend even the money that he has; he'll use it to pay down his debt and increase his savings. If savings rates just go back to where they were in the early '90s, it will take more than $300 billion out of the consumer economy. It will seem like a deep, long recession...but people will actually be better off as a result."

Bill Bonner
The Daily Reckoning Australia

• Maybe the “Cartoon” House Period is Over
• The “Consumer Economy” Was Always a Mockery
• Shutters, A Great Invention
• The Bonner Family Are Taking a Month Off to Paint Window Shutters
• Painting the Shutters With the Family

Why would a meeting on Australian interest rates begin with a discussion of foreign trading partners? Could it be that foreign demand for Aussie resources threatens higher inflation even more than Aussies hitting the shops with a credit card? Hold that thought.

The Reserve Bank may have some help in cooling demand with high oil prices. Higher energy prices may cool industrial production from Australia's trading partners. If the Asian countries eating up Aussie resources cool down a bit, then the flow of cash coming back to Australia from exports would slow down a bit too. Maybe, just maybe, the pressure on higher wages and business investment would relax.

But who knows? We've said before that the Reserve Bank is helpless to dent the demand for Aussie resources. It's that demand-long-term and enormous-we contend, that fuels inflation in Australia.

All that money flowing back into the economy turns into business, personal, or government spending. You can choke off domestic demand with higher rates. But the most favourable terms of trade in 50 years contribute to back-door inflation that's hard to contain with monetary policy.

Our friend Mike Graham in New Zealand has offered his services as a correspondent. We know Mike from our days in London watching European markets. He sends this report.

"Someone forgot to tell the New Zealand rural property market there's a slump on. While residential prices dropped or treaded water, rural property across the ditch actually reached a new record in May. The national farm median price hit $NZ1.86 million, surpassing April's $NZ1.81m figure. The price of a dairy farm has risen 50% in a year! H. L. Mencken said 'No one hates his job so heartily as a farmer'. Kiwi gumboot-wearers like Kerry Logue would beg to differ.

"Kerry's been getting up at an unspeakable hour to head off to the milking sheds for 35 years. But he's now looking forward to a retirement that would make many lawyers envious. His 113ha farm at Tomarata, north of Auckland, is on the market for $NZ2.8m, a price he'll most likely get. With money in the bank, a hobby 'do-up' villa near Wellsford and a home at Huia, you could say the 62-year-old is creaming it. "Thirty-five years milking is a long enough stint for anyone. My kids thought the old man was crazy still working seven days a week."

"Not as crazy as all that, it would seem. Of course, it's not just good old-fashioned hard-graft that means Kerry's golden years will be just that. He owes a billion people 6,700 miles a beer at his local pub.

"The best way to get rich in 2008 is hardly a secret. You find something that the Chinese want. You produce it. And you sell it to them. In Australia, you buy a mine. In New Zealand, you buy a farm.

"Chinese Premier Wen Jiabao made a confession to New Zealand Prime Minister Helen Clark at recent trade negotiations. His dream is not about a future in which every Chinese will own his own car, receive a world-class education or own his own house. It's a future where every Chinese child will be able to drink two glasses of milk a day.

"An odd aspiration, but Helen is hardly complaining. Thanks to soaring Chinese demand for dairy products New Zealand dairy co-operative Fonterra (NZX: FCGHA) announced in May it would pay farmers a record $NZ7.90 per kilogram for milk solids. ASB chief economist Nick Tuffley estimated the total cash injection would be $NZ9.6 billion this year. That's equivalent to about 6% of GDP, and up from $4 billion on last season.

"Ordinary consumers - already feeling the pinch of expensive oil, falling property prices and tightening credit - are hardly ecstatic. Thanks to China's new taste for strawberry milkshakes, dairy is now off the menu for many Kiwis. Fresh milk now costs 22% more than it did a year ago. Cheese, 60% more. But it seems that the good old New Zealand farmer could be milking it for some time to come.

Dan Denning
The Daily Reckoning Australia

• Inflation is an Artifice Caused by Government
• Australian Dairy Prices Up Due to Grain Prices
• British Lamb Imported From New Zealand
• Australia & China: Already Partners in the Commodity Boom
• Rio Scraps Deal to Sell to Aluminium Corporation of China

Early every morning, while most Americans are still in their beds, your editor joins a group of analysts and financial journalists to discuss the day’s news.

“What happened to the price of copper? Why are Asian stocks going down? Are they really going to cut rates today?” The answers are not always satisfying, but the questions keep coming.

And the question this morning was: what has really changed?

U.S. stocks held steady yesterday, but they’re down 5% so far this year. The dollar held steady yesterday too, but it is down for the year too – about 6% against the euro and the yen. The Europe- or Japan-based stock market investor has lost more than 10% of his money.

Meanwhile, the fall of the dollar has increased prices for imports. While the United States used to “import deflation” from Asia and elsewhere, now it imports inflation. Prices are rising all over the world.

Yesterday, European producer prices were reported rising at 6.1% per year. High prices have caused the biggest drop in retail sales on record. And yesterday, they had to call out the riot squad in Brussels, to battle fishermen who were kvetching about high fuel costs.

In China, retail prices are rising at an 8.5% rate – the fastest in 12 years.

In Russia, prices are going up at a 14.39% rate.

In Vietnam, the consumer price inflation rate is running at 25%.

In Venezuela, the inflation rate is 29%.

And in Zimbabwe...well, Zimbabwe is another story altogether, with inflation going up so fast they can’t even measure it. Prices are said to be increasing at 160,000% to 200,000% per year. But who can tell? There’s nothing to buy.

Back in Asia...the region’s central banks had hoped that Milton Friedman was wrong. They had hoped that a worldwide economic slowdown would reduce domestic inflation rates. So, they left their lending rates low – considerably lower than the CPI – in order to keep their economies turning over. In Thailand, for example, the central bank lends at 3.25%, while consumer prices rise at more than 6%.

Sound familiar? The United States also keeps its key-lending rate well below the inflation rate – and for the same reason. The Fed lends at 2%. Inflation was last clocked running twice as fast.

We pause here in honest admiration for our fellow investors – the kind of admiration we feel for members of a bomb disposal unit, or a knife-thrower’s assistant. What are we to think? They are lending money to world’s biggest debtor – the U.S. government – for 10 years at 3.94%. That’s yesterday’s yield on the 10-year T-note. If nothing changes, they will get nothing for their trouble. If inflation rates rise (or just happen to be understated), or the dollar falls, the speculation will blow up in their faces.

But along comes Ben Bernanke, with an apparent change of brain. Now, says the captain of the Fed’s rapid response recession-fighting team, further inflation is unwelcome in the United States of America. Supposedly, these words alone took $5 off the global oil price.

But what really has changed? Can the U.S. central bank really begin fighting inflation in a serious way?

The feds have discovered the same two things that their Asian central banker colleagues have found out: that the globalization street goes both ways...and that Milton Friedman was right. Inflation is a monetary phenomenon, observed Friedman. When you increase the amount of money in circulation, ceteris paribus, prices are going to go up. That they didn’t go up much in the last 15 years is merely because there were important other trends going on – notably, globalization, which was driving down prices. But now, traffic on the Avenida de Globalization is going in the other direction. And just as it was very difficult to cause inflation while globalized markets were cutting prices, so is it very difficult to stop inflation when globalized markets are increasing them.

*** Can the Fed really begin fighting inflation? Ah, dear reader...do you see the cruel twist to the story?

While the Fed couldn’t seem to create inflation in those wonderful years of the Great Moderation...now, it probably can’t do much to stop it. The U.S. imports an Everest of stuff from overseas. And stuff made overseas is becoming more expensive. The Fed can raise rates to try to cool the U.S. economy and reduce the amount of stuff Americans buy. But those darned Asians and Europeans can still buy more, and prices can still go up.

Besides, any further ‘cooling’ of the U.S. economy is risky. It could freeze up.

The crisis is said to be over on Wall Street. But the Financial Times says new IPOs are being taken off the schedule...short action on Lehman Bros. is at a record level (speculators are betting that the company is going down) and Moody’s says it might downgrade credit ratings for MBIA and Ambac.

The money just isn’t flowing as fluidly in Manhattan as it used to. An AP story tells us that apartment sales were off 21% in the first quarter. And over on Long Island, where the Wall Streeters have their weekend homes, lenders are said to cutting off home equity lines.

In the center of the country, bankruptcy filings are up 27% in Illinois. And out in Las Vegas, the mortgage fraud capital of the world, a $5 billion casino project has just been cancelled.

And this just in – California is officially suffering a drought.

Under these conditions, we’d expect Ben Bernanke to make some gestures toward protecting the dollar and reducing inflation. But we’d also expect that most of the air coming from the Fed will be hot, not cold.

“The Fed seems to be trying to create a situation whereby they are seen to be fighting inflation, simply by not lowering rates any further,” says MoneyMorning. “This is because, while the Fed may have no interest in fighting inflation, they have a big interest in fighting what they call ‘inflationary expectations’. In other words, they are more interested in fighting people’s perception of the problem, rather than the problem itself.

“The problem is that when inflation spread into homes and stocks, everything was just fine – unless you were a saver who rented of course. Now that inflation has moved from asset prices into energy and food, then there is a real problem for those who were unprepared....

“The next wave will be in the form of a derivatives crisis: the oft-mentioned collateral debt obligations and credit default swaps. It is apparent that few people really understand what they are and how deep they go. That is bad news. Because it means when the crisis hits, people are more likely to panic. Panics tend to be disproportionate to the problem, particularly when trust in institutions has disappeared, as is the case with banks today.”

*** To put it another way, the war between inflation and deflation is still going on. Inflation is in the news so much that you might think it has won. Just look in the papers; you can practically see the victory parades and hear the music playing.

But deflation isn’t giving up and isn’t going away. Americans are deep in debt. And debts cause a man to pull back...to retrench...to downsize. We see that in the headlines too. Retail sales are going down. People are driving less. They’re trading in their SUVs for smaller, more economical cars. They’d like to trade in their big houses too – but they can’t find a buyer.

Downsizing means spending less money. And spending less money means fewer sales...and lower incomes...and fewer profits. It means an economic slump – and, typically, falling prices.

In today’s globalized world, that slump would have to reach worldwide proportions in order to have a major effect on key commodity prices, such as oil and grains. But that is probably coming.

The cure for high prices is high prices. You’ve probably heard that before. It describes the way markets work. Prices go up. The higher prices encourage consumers to use less...and encourage producers to produce more. It’s not long before the supply increases...and demand falls. Then, prices adjust downward.

Part of the reason that oil is so expensive is that many places subsidize it. Most governments in Asia and South America have held fuel prices down in order to placate consumers and stimulate growth. They’re now being forced to raise prices. Yesterday, for example, Malaysia announced a 40% increase in fuel prices – sure to dampen demand.

And so the world economy stumbles and lurches forward.

Ben Bernanke may make a feint in the direction of fighting inflation – maybe raising rates slightly. Oil will drop back below $100. Bonds will rise. But consumer price inflation may still not go down; it may actually continue to worsen in the United States, as the economy sinks further into a slump. Then, the next phase of the War Between Inflation and Deflation can begin.

Bill Bonner
The Daily Reckoning Australia

• BRIC – Brazil, Russia, India and China Suffer High Rates of Inflation
• Inflation: Enemy Number Two
• The Ghost of ’70s Inflation and the Ghost of ’30s Deflation Will Scare the Living Daylights Out of Us
• The “War” Between Inflation and Deflation Has Produced Plenty of Noise and Casualties
• The “War” Between Inflation and Deflation Has Produced Plenty of Noise and Casualties

Ah, dear reader...just a little dignity, a little grace, a little courage and beauty. That’s all we ask. Can we find it on Wall Street? In Washington? In politics or economics? We hope so, because that’s all we have to work with here at The Daily Reckoning.

Oil went up yesterday. Asian markets fell – with Japan taking its biggest hit in six weeks. And the dollar fell. Speculators are beginning to bet that the Fed will cut rates for an 8th time; that’s the world on the street. As we predicted, the first 7 cuts have done wonders for the prices of oil, gold and commodities...but little for the real economy. Oil has gone up 60% in six months...putting big pressure on U.S. household budgets. Now, instead of taking the hint – that it’s time to go in the other direction, by raising rates to head off rising prices – speculators think Ben Bernanke will continue battling deflation with further rate cuts. Maybe, maybe not...but our guess is that it doesn’t matter. Even if the Fed raises rates, it is unlikely to raise them enough to block the consumer price inflation already in the pipeline.

In economic theory, the supply of money is the key to prices. Prices should remain more or less stable when the supply of money increases at the same rate as the supply of goods and services. But in the last 15 years, the U.S. money supply increased about twice as fast as GDP. The surprising thing was that prices didn’t rise. That was the period known as the Great Moderation. As reported here yesterday, food prices only increased at a 2.5% annual rate...even though money supply, MZM, was going up at nearly 9%.

We have given our opinion as to why consumer prices did not go up. We guessed, too, that those trends that labored so hard to hold them down have now walked off the job. Prices now seem to be adjusting to a higher money supply, with food up 4% last year, officially. Unofficially and anecdotally, consumer prices are rising at about 10% per year.

But while consumer prices were stable during that 15-year period...asset prices frequently went into bubble territory. And now, we await the Final Bubble, dear reader...about which we will have more to say later in the week.

In the meantime, the winner of the Enron Prize, and former headman at the Fed, Alan Greenspan, is in the news this morning. The Financial Times reports that he believes “there still greater than 50% probability of recession.”

Warren Buffett, on the other hand, says recession is already a fact of life. And he says it will be “deeper and longer that people expect.”

The old timer’s definition of a recession was ‘when your neighbor loses his job.’ When you lose your own job, it’s a depression. How many people have lost their jobs in this downturn? Well, for the answer to that question we look to the same people who give us the official inflation numbers – the apparatchiks at the U.S. Labor Department. Therein, of course, hangs a tale...and we will let Dana Samuelson of Danagold tell it:

“The average person judges a recession mainly on employment. If jobs are available, then the economy is holding up. If jobs are scarce, the economy is poor. By that standard, the economy is really struggling, with payrolls down in each of the first four months of the year. But the headline figures, again, don’t reflect the lived reality of Americans. At 5.0% in April, down from 5.1% in March, the current BLS unemployment rate is relatively low by historical standards. Yet the number of jobless Americans of prime working age, that is, men aged 24 to 54, is historically high at 13.1%. Most of these people don’t qualify as unemployed but they are nonetheless out of work.

“Why don’t these would-be workers show up in the headline statistics? Mainly because the government’s definition of the unemployed includes only people who do not have a job, have actively looked for work in the four weeks preceding the survey, and are currently available for work. But it excludes the self-employed, 1099 workers who can’t get enough contracts, those working part-time or on commission only, and the under-employed (like real estate agents waiting tables or mortgage brokers bagging groceries). It also doesn’t count those who’ve given up looking for work altogether – a category known as ‘discouraged workers,’ defined as persons not currently looking for work specifically because they believe there aren’t any jobs available for them. Some analysts say this particular group of jobless Americans – who believe their prospects for finding a job are getting ever dimmer, yet who don’t figure in the computation of the unemployment rate – represent the nation’s dire job situation. According to John Williams’ Shadow Government Statistics, the primary source for unbiased economic data, if adjusted for ‘discouraged workers,’ the actual unemployment figure for April rose to 13.1%, up from 13.0% in March. Now that’s recessionary!”

Real inflation at 10%? Real unemployment at 13%? Maybe. But we have not quite seen the fall off in consumer spending that these numbers suggest...

...stay tuned.

Bill Bonner
The Daily Reckoning Australia

• Economy Has to Grow at 1% to Stay Even With Population Growth
• Job Losses From Private-sector Rose Since Beginning of Recession
• Consumer Prices for the Essentials are Skyrocketing
• Bad News if You Are Afraid of Inflation in Consumer Prices
• America’s Service Industry is responsible for Low Wages

Yesterday brought more sorrows. Stocks fell – with the Dow down 227 points. Oil rose to $132. The dollar fell to $1.57 per euro. And gold hit $928.

But what’s this? Bonds – strangely – fell too. This could be a very important, like the dog that didn’t bark. Usually, when stocks fall bonds go up. Investors anticipate lower yields as the economy cools and fewer borrowers compete for funds. But now, the bond market seems to be worried about something else...and we think we know what it is.

We have long mistrusted numbers. And we especially distrust numbers coming from the Labor Department, public officials of any sort, or Wall Street, or the media, or Congress, or the family.

“I saved a lot of money by buying this jacket,” a daughter reported yesterday. “It was on sale. Don’t you like it?”

“Well...yes...but how much would you have saved if you never bought it at all?”

“Daddy...don’t be silly...I needed a summer jacket....”

Maybe we are being silly today...but we see money slipping through our hands. And so does everyone else!

Prices are going up for nearly everything – milk, bread, gasoline, liquor...all the essentials.

In the United States, reports Martin Hutchinson, the official inflation numbers are the worst in 17 years...but the raw numbers even more alarming. Of course, the raw numbers are never even mentioned. They are like a forgotten aunt, consigned years ago to a nursing home; nobody comes to call...nobody even asks about her.

In March, the raw data showed consumer prices rising at a 10% annual rate. But by the time the Labor Department’s goons got finished with it, they reported a CPI going up at an annual rate of only 3.6%. ‘Seasonal adjustments,’ they called it. Then, in April, when the raw data came in at a 7.2% annual inflation rate, they seasonally adjusted it down to only 2.4%. They didn’t seem to notice that the season had changed!

Hutchinson: “Both adjusted’ figures were greeted by the stock market with a sharp upward move. In the ten years to 2007, no seasonal adjustment has ever exceeded 0.3%, plus or minus; the probabilities that the March and April seasonal adjustments were randomly arrived at by the same method as those of the last decade were thus 0.18% and 2.3% respectively (so the probability of two such anomalies in successive months was 0.0041%, about 1 in 25,000.) If the raw March and April figures are adjusted by the average March and April seasonal adjustments of the last decade, consumer price inflation in those two months averaged 7.4% per annum.”

You can fool some of the people all the time, said Abraham Lincoln. He didn’t know any modern economists or professional fund managers. But he must have anticipated them. They’re pricing stocks and bonds as if inflation were still under control – on the Labor Department’s say so.

Who knows? Maybe they’ll turn out to be right. Stranger things have happened. But here at The Daily Reckoning ...we reckon prices are rising more than most people think...that’s there’s more inflation to come...and that the bond market is catching on. That’s why bond prices went down yesterday; investors are worried about inflation. At long last – perhaps – the bond vigilantes are awaking from their long, deep slumber.

Readers will remember the bond vigilantes – perhaps only by reputation. Back in the ’70s inflation rates rose. Bond buyers took a terrible beating. Then, they strapped on their guns. Henceforth, it was said, the feds couldn’t get away with causing inflation; because the bond market wouldn’t let them. As soon as bond investors saw inflation coming, they would act like vigilantes – selling off their bonds and forcing up yields. Higher yields cooled off the economy...and reduced inflation.

By way of full disclosure, this is not the first time we thought the bond vigilantes were saddling up and riding off to stop the Fed from destroying the dollar. At least twice in the past 5 years we thought so...only to find that they were just on their way to a saloon to join the party!

Back to the first point – that the numbers lie: A couple of English newspapers had the same suspicion – that official numbers were bent and distorted, always to the downside, of course. So, they sent their reporters out into the real world to buy things.

“The results are ‘alarming,’ says one tabloid...“the most savage increase in living costs for a generation.” What did the papers actually find? The Daily Express came up with an increase in consumer prices over the last 12 months of 11.5%. The Daily Mail ’s tally came in at 15%.

That’s getting to be serious inflation. And we suspect there’s more coming. And less, too.

A news story in the Financial Times tells us something very interesting. “The gap between input prices and what can be passed on to consumers is at its widest for 20 years.” For example, a 4-pint bottle of milk has gone up 16.5% in the United Kingdom. The price of milk from the farm has soared nearly three times as much – 45.8%. Or take bread. Wheat is up 56.9% over the last year. But a loaf of bread has only gone up only 8.5%. Crude oil is 62% more expensive today than it was a year ago. But a can of oil...or petroleum products generally, at the retail level...are up only 25.4%.

What does this mean? Probably two things. Maybe more. First, input prices have jumped so fast retail prices have not been able to keep up. It may also mean that retailers don’t think the raw output prices are permanent...or that they, the retailers, can afford to pass them along without losing customers. It may also mean that commodity or wholesale prices have gone up too far, too fast.

One thing is certain, the gap can’t last. The retailers can’t buy oil 62% higher and sell it only 25% higher – not for long. Either the price of crude comes down...or the price of retail petroleum products goes up.

Which will it be? Inflation or deflation? More inflation at the retail, consumer level...or a collapse of commodity/wholesale prices?

Our guess, as usual, is that it will be both.

*** There are two types of consumer price inflation. There is wage-push inflation...and cost-pull inflation. Or, is it the other way around? Doesn’t matter. The most familiar type of inflation comes when an economy heats up...companies need more labor...so workers demand more money. Employers meet the new wage demands...and then raise prices to maintain profit margins. Result: consumer price inflation.

The less familiar type of inflation happens when retail prices are pulled up by higher input costs. This is a very different kind of inflation because it provides consumers with no way to pay the higher prices. So far, we’ve seen very little increase in wages. As prices go up, consumers must cut back. This has the obvious effect of reducing demand...and reducing price pressure. Just as wholesale prices work their way down to consumer prices, so does consumer resistance work its way back up to producers. Effect? De horses go down and den dey come back. Doo dah. Doo dah. Producers cut back on production in the face of lower demand. Result: prices fall.

But here we introduce three wrinkles – each one the size of the Rocky Mountains.

First, have you heard that word: “decoupling?” We were afraid to use it; we thought it described the end of a porno movie. But now we discover that it really refers to the parting of the ways...between the mature economies of the United States and Europe...and the growing economies of the rest of the world. It was presumed for a very long time that “if the U.S. sneezes, the rest of the world catches a cold.” Well, now we’re not so sure. The rest of the world seems to have developed immunity to America’s germs. We don’t know; but maybe a consumer slowdown in America would not keep the Chinese, Indians and Russians from buying. Result: the normal corrective feedback loop would be twisted and broken. Prices would still go up, even though the U.S. economy was in a slump. This would put Americans in a terrible position – where they were earning less money but their costs of living were still going up.

Second, global prices are denominated in dollars. And the custodians of dollars – the feds – are determined to keep Americans spending money, even if they don’t have any. ‘Rebate’ checks... mortgage bailouts...lower rates...lower lending standards – the feds are going all-out, trying to keep the money flowing. Our guess a year ago was that this flood of liquidity would buoy up oil, gold and commodities. It certainly has done that. But will it continue?

This brings us to our third crease. Many commodities seem to us to be near bubble territory. Oil, for example, is an important commodity. But it’s just a commodity. It has users. It has producers. Barring a war, the relationship between supply and demand doesn’t change overnight. How is it possible, then, that the price should double in less than two years...or that it could go up another $25 before the end of the year (as much as the entire oil price 5 years ago), as T. Boone Pickens predicts? How could it go to $200, as Goldman predicts?

The answer is simple – the price is rising on speculation, not supply and demand. Oil may already be in a bubble.

Five years ago, there was only $13 billion invested in oil market indices. Now, there’s $260 billion, according to an article in the FT . In the futures market, oil is usually sold short – as oil companies hedge future production. In 1990, only 13% of open interest was long. Today, 58% is long.

Besides, markets work. When prices go up it draws forth new supply. In yesterday’s news, for example, we found that oil companies are spending four times as much on exploration and drilling as they did eight years ago.

Of course, there are reasons to think oil may go higher – a lot higher. But markets are markets...and bubbles are bubbles. And there’s one thing you can count on – bubbles always pop.

Bill Bonner
The Daily Reckoning Australia

• Consumer Confidence is at its Lowest Point Since 1980
• Consumer Prices are Rising at About 10% Per Year
• Bad News if You Are Afraid of Inflation in Consumer Prices
• High oil Prices are Now Oozing into the Entire Economy
• Commodity Inflation Causes Consumers to Cut Back on Spending

But here’s some good news:

Last month, the price of gasoline went down 2%, says the Labor Department.

Wait a minute. Do you remember gasoline prices going down in April? We don’t. As we recall, oil prices were soaring...and so was the price of gasoline.

We’re beginning to sniff something funny in the air...a rat.

It was largely thanks to this reported drop in prices at the pump that the Consumer Price Index registered a scant 0.2% increase for the month of April. And it was largely because of this low inflation reading that the yield on the 10-year note stayed below 4%, says Gary Dorsch.

Our view is that higher consumer price inflation is in the pipes and will soon be backing up in the bathtub drains. Dorsch says the U.S. money supply is now increasing at a 16% rate; higher inflation can’t be far behind.

Generally, we don’t trust numbers. Who can trust a 5 after all – with a bottom like a communist sickle and its top nicked from a swastika? Who can trust an eight – wandering back and forth and never getting anywhere? And what about the zero? What does it mean? You put it in front of a number and it means nothing. You put it behind...and all of a sudden you’ve got 10 times as many. So, let’s look a little more at those numbers – that is, at the crooked 4s, the slick 6s, and the empty 0s – put out by the feds.

Getting back to the price of gasoline, we check the records from NY gasoline futures trading and find the price actually rose 12% in April. How come the feds put it down as minus 2%? Turns out, they made a ‘seasonal adjustment.’ But turning plus 12 into minus two sounds like more than an adjustment; it sounds like either magic or major surgery...like turning a prince into a frog or a fat man into a slim woman.

Elsewhere, we find the feds working their magic on all the primary numbers. The IMF, for examples, says food prices rose 43% last year. Yet, after the feds waved their wands, U.S. food costs were up only 5.1%. And import costs rose 15% year to year – according to the numbers when they first got off the boat. But by the time the Labor Department statisticians had finished ‘adjusting’ them, they were down to only 0.2%.

Only investors, of course, are gullible enough to believe the government numbers. Consumers believe the numbers they see at the checkout counters and the pumps. What they see is sharply rising prices. Even newspaper reporters shop...and even they see what is happening.

“Inflation may be worse than the consumer price index shows,” suspicions USA Today .

“Food costs jump most in 18 years,” notices the Washington Post .

Consumers don’t figure out consumer price increases – they pay them. The combination of lower wages and higher prices squeezes them like thumbscrews. What can they do?

Californians may be among the last Americans to wake up in the morning, but they’re the first to spot a trend. And the big trend in California today is recession.

House prices have fallen more in California than anywhere – down 29%, according to the California Realtors Association. A thousand foreclosed houses are auctioned every day in the Golden State. And joblessness hit 6.2% in March.

What are Californians doing to cope? They’re doing just what you’d expect. “Californians are cutting back on spending,” says James Saft in the International Herald Tribune. “Besides causing woes for state and local government, the cutback is giving California’s economy another knock and makes further job losses, home repossessions and banking problems more likely.”

Nordstrom says a third of its sales come from California and sales overall are down 6.5% in the first quarter. Starbucks says it is just not selling as much mocha in CA as before. Jack-in-the-Box, too, says the Californians aren’t buying as much of its dreadful food.

Meanwhile, other towns – such as Modesto, Stockton and Merced – are said to have 60% of their homeowners “upside down,” with more mortgage than house. Their unemployment rates are above 10%. And Vallejo, a city in Northern California, is taking the coward’s way out. It is slashing its wrists – it says it will declare bankruptcy.

Welcome to California, dear reader. Welcome to the future.

Bill Bonner
The Daily Reckoning Australia

• The Dow Gives Up the Post-ZIRP (Zero interest rate policy) Gains
• Crude Oil Becoming Much Harder to Find
• Consumer Prices for the Essentials are Skyrocketing
• California Has Run Out of Money
• The Business Bankruptcies and the Personal Bankruptcies

"Cheap clothes may soon become a thing of the past," reports MoneyWeek.

"Simon Wolfson, the chief executive of Next, warned that clothes prices may have to rise by up to 5% to offset rising costs from China and Europe. The strong euro and demands for higher prices from Chinese manufacturers mean that 'we will begin to see higher costs coming through in spring, summer next year. The way that retailers are going to have to cope with this is to pass the increase on.'

"That 5% may not sound like much, but we haven't seen clothing price inflation in more than 10 years. And once the price of clothes starts going up - well, nothing will be getting cheaper any more."

Well, it was fun while it lasted - The Great Moderation, that is. The United States could emit pieces of green paper without causing consumer prices to go up. Because globalised wages and finished product prices were falling fast enough to offset it.

But inflation is back. Like spring pollen and sulphurous pollution, it is darkening the air in China. And now people in Europe and America are beginning to rub their eyes and sniff, too. Gasoline hits new records - along with the oil price - every week. Food prices are so high that many nations are taking emergency action to control them. Soon, consumer price inflation will be a problem for nearly everyone.

*** Oh... yes... the oil market. Nations don't have friends, said one savvy strategist, they only have interests. And since the beginning of the Industrial Revolution, one primary interest of ambitious nations was securing supplies of energy.

Alan Greenspan told the world that the war in Iraq was largely "about oil." John McCain says that if we didn't have to import oil it would "prevent us from having ever to send our young men and women into conflict again in the Middle East." Sounds like he thinks the war is "about oil" too.

But one thing the war in Iraq has shown is that American cannot control its oil supply - even when it is fool enough to send in armed troops. The price of crude was only $26 a barrel when the war began. It was $126 yesterday.

*** "Yes, there'll be many more crack-ups," said a young hedge fund manager who came over for a drink on Sunday, "but in the long run, the emerging markets are going to grow much more than the U.S. or Europe. That's where I want my money."

He put his money into India, primarily. The results were spectacular - until 6 months ago. Then, almost all the go-go markets went. Still, looking at the big picture, over the long term, he is probably right. The emerging markets are probably a better place for your money than the United States.

The fundamental conceit of Americans over the last 50 years was that the foreigners were so hopelessly incompetent that even if we gave them a helping hand they could never challenge us. But now they are challenging us... and beating us at our own game. They invest more, save more, and produce more than we do - even the communists. Meanwhile, we focus on soft service industries - health, finance, and education - where the actual return on investment is hard to measure and often negative.

Bill Bonner
The Daily Reckoning Australia

• Emerging Markets in the New World Disorder
• The Century of the Emerging Markets
• Investors Sold Japan Along with the Emerging Markets
• Emerging Markets Means Only One Thing to Us: A Buying Opportunity…
• BRIC – Brazil, Russia, India and China Suffer High Rates of Inflation