One Sure Winner as We Fight Deflation

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[Editor's Note: We are constantly surveying the investment world for ideas, hidden stories and unique perspectives to share with you. One of our favorite spots to look is The Aden Forecast, which has been written by Mary Anne and Pam Aden for decades. This recent article they crafted for you is testament to why we value their insight and analysis.]

For the past six months or so, we've talked a lot about the velocity of money and its effects. Increasingly, it's become the most important factor in understanding the markets and the uncharted waters we're currently navigating.

For years we've been delicately sailing between the Scylla and Charybdis of our day, between inflation and deflation. And the sharp drop in gold was yet another slide towards deflation's shores.

Meanwhile, the world's central bankers have been at the helm, doing all they can to keep deflationary pressures at bay and steer hard toward inflation.

But despite their unprecedented global efforts, including massive money stimulus and near zero interest rates, the rocky shores of deflation loom larger and larger. Here's why...

2008 MELTDOWN WAS START

During the outset of the 2007-08 financial crisis, the world was brought to its knees. Don't forget, this was the biggest crisis and recession since the Great Depression, and for a while the global financial system was literally hovering on the verge of disaster.

The banks had lent money to everyone, and these bad loans and reckless policies resulted in the collapse of the subprime mortgage market. In an environment of extreme tension, some of the biggest lenders like Lehman Brothers went under, but others were saved to keep things from getting worse.

After that, the banks were scared, they had to regroup and get their houses in order. They obviously didn't lend money.  Instead they became extremely conservative. Even worthy borrowers were not granted loans.

This played a big part in the overall economy. It didn't rebound and grow normally following the recession.

So the Fed had to pick up the slack with their super easy monetary policies to get the economy back on track. They didn't want to repeat the mistakes made during the Great Depression and, in the process, they've tripled the money in circulation since 2008.

The Fed succeeded, sort of. The banks still weren't lending so the result has been a lackluster recovery and high unemployment for the past few years. Why?... This brings us back to the velocity of money (see Chart 1).

Deflation

VELOCITY DOWN

As you can see, the velocity has declined rapidly in recent years and it's now at a 60-year low. This is a huge deal and we're increasingly convinced this is the main factor tipping the scales toward deflation.

Declining velocity means the Fed can produce all the money it wants, but this money isn't turning over. In other words, since the banks aren't lending, the money is just sitting and the Fed has no control over it.

Under normal circumstances, banks lend money to businesses for expansion and growth. Consumers borrow, and previously it was part of doing business for the banks to lend out about eight times the amount of money they had on hand.

This is called the money multiplier and the higher it is, the more it spurs robust economic growth, rising velocity and money supply. The money multiplier also has been very low since the 2008 financial crisis.

... LOW INFLATION

This, in turn, is a stagnant environment for inflation and that's why it hasn't surfaced like it normally would. That is, market forces have overpowered the Fed and the other central banks.

But there is some good news. According to the latest Fed Senior Loan Officer survey, banks are starting to lend, especially to businesses and commercial real estate.

This is a big deal considering they've been paralyzed for the past five years. And even though only 19% of the banks indicated they're easing up on lending, it's a start. If other banks now follow suit, then eventually we could see deflationary pressures ease up.

If so, that would certainly be the better option, but we'll see what happens. Keep in mind, the debt load is massive and the automatic spending cuts are not even causing a dent (see Chart 2).

Deflation

Also important to consider are demographics.  The world population is aging and that means they're not borrowing and buying as much as they did before.

This, together with the debt load, could keep the economy sluggish and the scales tilted toward deflation.

LOW RATES HELP... A LOT

On the other hand, we also know that interest rates are going to stay low for a couple more years. This should help boost borrowing and the velocity, as well as easing deflationary pressures.

If that happens, then we could indeed see inflation shoot up at some point in the future. The potential is clearly there and all it needs is a spark, like a shift in sentiment, to ignite inflation.

In fact, many feel that the longer deflation drags on, the longer the Fed will keep producing money and this makes sense.

We know deflation is the Fed's #1 enemy, so it's going to fight it tooth and nail. And the longer it does, the greater the future potential for surging inflation and gold.

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Mary Anne & Pamela Aden are well known analysts and editors of The Aden Forecast, a market newsletter named 2010 Letter of the Year by MarketWatch, which provides specific forecasts and recommendations on gold, stocks, interest rates and the other major markets. For more information, go to www.adenforecast.com