The One Thing Central Bankers Fear More than Gold

The One Thing Central Bankers Fear More than Gold

Governments don’t like it.

Central banks hate it even more.

And the press is out to convince it’s bad for you…

But the word they dare not utter isn’t as bad for you as they want you to believe.

And there’s one investment that will help you weather the storm…

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The d word

The d word has been everywhere in the past week.

Even I joined in with the masses and wrote about it last week.

And based on what I read over the weekend, what central bankers fear most is going to get some coverage over the coming weeks.

I am, of course, talking about deflation.

Check this out from Bloomberg this morning:

The economic contraction wrought by efforts to contain the coronavirus is shredding inflation. Now deflation, a prolonged period of falling prices, is stalking the globe. The collapsing oil market is both a symptom of weaker demand and cause for a deepening slump.

That’s a mistake. For decades, inflation was the most-preferred way to assess economic health; whatever its flaws, targets in the vicinity of 2% gave global central banks a quantifiable guidepost. If there are alternatives, they haven’t been proposed.

This is the thing when it comes to writing about deflation, the angle you’ll see from the press is always towards shaping your view that it’s bad.

But is deflation really that bad?

As fancy sounding as it is, deflation simply means the falling prices of goods and services. That’s in contrast to inflation, which is rising goods and services.

The thing is though, the only people deflation is really bad for is governments and central bankers.

The argument behind ‘inflation is good’ is driven by central banks and governments. If the value of goods and services will rise in the future, people are more likely to buy those items today rather than tomorrow and risk the price of those goods increasing.

Whereas for deflation, people expect prices to fall in the future, so purchases are delayed as folks hope they’ll get it cheaper later on.

Central banks base their central banking business on anything that ‘stimulates’ the economy and encourages it to grow.

Therefore inflation forces us to buy things earlier than we would have, bringing demand forward. In other words, we are more likely to buy more stuff today rather than risk it getting more expensive. And buying things sooner rather than later benefits others in the economy.

That way, the economy ‘expands’ because we continue to consume items.

If we travel a little further into the economic textbooks, prices going higher is meant to encourage the value of wages and assets to increase. They say we get wealthier as ‘inflation’ filters through the economy.

And here’s the crux of inflation that you don’t normally hear about.

The higher prices and wages increase…the lower the debt burden becomes.

That is, if your wages and asset values are rising, then your debts in theory become smaller against rising prices. Assuming the debt value is fixed (like with a house or a car loan, for example).

Central bankers love inflation, because by pulling a few levers they believe they can stimulate demand, increase prices, and encourage debt while ‘growing’ the economy.

Deflation is the opposite of all this.

Falling prices delay consumption. Why buy today what you can buy tomorrow? If prices are falling, there’s less pressure on companies to increase wages.

Furthermore, it reduces a bank’s willingness to lend for an item if there is a risk the goods will be worth less than the debt attached.

And more to the point, it makes the existing debt much harder to pay off…

To boot, if we are all consuming less, the economy doesn’t ‘expand’ by a central banker’s playbook.

Investing with the turmoil

So, where do investors go from here?

If prices are falling, what does that mean for assets? How are you meant to invest when the value of things around you are predicted to fall?

Central banks and governments are looking for ways to restart the economy and get things back to normal.

The problem is, these aren’t normal times. So using normal ways of doing business is a quick way to the poor house.

There is one investment that tends to do well during periods of deflation though…

It’s just that we’ve been taught to forget about it.

Historically, gold has proven to be an excellent hedge against inflation. This is because prices tend to rise when the cost of living increases.

Believe it or not, gold does the same thing during deflationary periods too.

This was analysed by historical gold expert Roy Jastram in 1977. As Jastram pointed out in his book The Golden Constant, it’s not that gold’s nominal price increases during inflationary or deflationary periods…it’s that gold’s purchasing power increases.

The nominal price, is another way of saying the current dollar value price. Whereas the purchasing price is what gold can buy.

During the deflationary period of 1814–30 in the US, prices fell by 50%. However, Jastram discovered that the purchasing power of gold rose 100%. It was a similar again to the next American deflationary period in 1870–1914. Overall prices dropped 65% in this time, but gold’s purchasing power rose 40%.

This is particularly important, as during 1870–1914 the gold price was fixed to US$20.67 per ounce.

The point is, in both examples the prices of goods fell. But each time gold’s ability to buy goods increased.

Here, even during a time where the gold price was fixed by the government, prices of goods and services still fluctuated. Yet the price of gold remained constant.

Gold might not be the answer to all of our problems right now.

But prior to central bank intervention, gold proved to be a natural defence to economic turmoil.

Until next time,

Shae Russell Signature

Shae Russell,
Editor, The Daily Reckoning Australia