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April 30, 2008

Growth and Inflation Debate
by Puru Saxena

BIG PICTURE - Over the past few months, we have heard numerous times in the media that the Federal Reserve and the other central banks have a choice between economic growth and rising prices (wrongly defined as inflation). In fact, most investors have been brainwashed into believing that policies which stimulate strong economic growth automatically result in higher prices within the economy. For example, in the current situation it is now widely believed that by slashing rates and adding liquidity to the financial system, the Federal Reserve is opting for strong economic growth in the US which in turn is causing the consumer price levels to rise. In other words, most people are being hoodwinked into believing that the prices are rising due to strong growth!

In my view however, the above assessment is totally incorrect. After all, any student of economics will be able to tell you that if the money-supply was constant, strong growth would not lead to higher prices. On the contrary, strong economic growth (increase in the production of goods and services) would result in price declines as the supply of "things" increased in relation to the amount of money available in the economy. Conversely, a weakening economy (decrease in output) would assert upward pressure on prices as the production of goods and services declined in relation to the amount of money available to purchase those "things".

In the current monetary system however, the supply of money is not constant and the central banks of this world are free to create as much inflation (money-supply growth) as they want. There is a catch though - the central banks can only do so as long as they can keep inflationary fears under check by constantly reminding the public of the threat of deflation. Turning over to the current situation, it should not come as a surprise then, that in the past few weeks the media has published various stories comparing the recent downturn in the US to the Japanese deflationary bust or the Great Depression of 1929. In my opinion, this "deflation" propaganda is crucial to further promote the Federal Reserve's agenda of creating even more inflation as a "cure" for the ailing economy. Let there be no doubt that the Federal Reserve is now desperately trying to inflate the system via rate-cuts, pumping of liquidity and bailouts. And it is this monetary inflation and not strong economic growth which is causing commodity and consumer prices to rise. Unfortunately, for the average American, this is occurring at a time when their economy is weakening, incomes are falling and unemployment is rising. In other words, I would argue that the Federal Reserve's inflationary efforts are making things a lot worse for the majority of people.

My intention is not to criticise Mr. Bernanke as I honestly feel that he is simply a cog in the wheel, an insignificant part within the overall system. Rather I sympathise with him since he is now dealing with the mess which Mr. Greenspan created by leaving the Fed Funds Rate at a ridiculous 1% long after the US recession ended earlier this decade. It is my firm belief that Mr. Greenspan's ultra-loose monetary policies in the aftermath of the technology bust largely created the ongoing financial and credit crisis. And now, Mr. Bernanke is left with no choice but to continue with the inflationary program or else there would be a global economic depression. Figure 1 clearly shows that due to Mr. Greenspan's record-low interest-rates, American home prices sky-rocketed between 2001 and 2005. However, they have fallen sharply in the past 3 years and show no sign of bottoming out.

Figure 1: Home prices falling in the US

Source: www.chartoftheday.com

As an investment-manager, it is not my role to pass a moral judgement on the actions of central banks and governments. To be fair, given the level of debt imbedded in the West, central banks have no other option but to inflate. The problem though for the US economy stems from the fact that this newly created money seems to be finding a home in commodities rather than financial assets. It is interesting to note that since the Federal Reserve started slashing interest-rates in August last year, energy, metals and food prices have gone to the moon whereas the US Dollar and American stocks have plummeted. Unfortunately for the US establishment, the "cure" of monetary inflation seems to be going horribly wrong as it is translating into even higher consumer and producer prices. Now, veteran clients and subscribers will recall that I have long maintained that this decade would belong to commodities and the markets are proving me correct.

Over the past few months, the prices of commodities have gone through the roof due to supply and demand imbalances and massive monetary inflation. However, given the turmoil in the markets and loss of confidence, resource stocks have been punished by investors. This development is strange to say the least and it has paved the way for a massive buying opportunity in the most coveted sector of the future. I find it absurd that the investment-community is dumping quality resource stocks at a time when the underlying commodity prices are super strong. At the end of the day, businesses are valued based on their corporate earnings and with sky-high commodity prices, I can assure you that elite resource-producing companies are going to announce fantastic results in the months ahead. Today, top-quality diversified mining companies are selling at 12-13 times earnings (bear-market valuations) and I can only guess this is due to the fact that most people expect commodity-prices to crash in the months ahead. However, if my homework is correct and commodity prices continue to soar in the future, we will see a major re-rating in the valuations of resource-producing stocks. Some of you may remember that during the technology mania at the turn of the millennium, technology companies (even dodgy ones) sold for ridiculously high valuations. Well, we can expect to see the same type of madness in relation to commodity stocks in the future.

Puru Saxena
www.purusaxena.com

Puru Saxena publishes Money Matters, a monthly economic report, which highlights extraordinary investment opportunities in all major markets. In addition to the monthly report, subscribers also receive "Weekly Updates" covering the recent market action. Money Matters is available by subscription from www.purusaxena.com.

An investment adviser based in Hong Kong, he is a regular guest on CNBC, BBC, Bloomberg, NDTV Profit and writes for several newspapers and financial journals.

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