True Inflation is 6% to 7%

Official Measures Game the Statistics

Paulson is Largest Holder of GLD

Apr 21, 2010, 15:02 ET from Rosland Capital LLC

NEW YORK, April 21 /PRNewswire/ -- Jeffrey Nichols, Senior Economic Advisor to Rosland Capital (www.roslandcapital.com ), had the following commentary based on recent developments:

Friday's news that America's most distinguished and powerful investment firm had been charged with securities fraud by the U.S. Securities and Exchange Commission sent stock and commodity markets sharply lower.  Gold was no exception, briefly falling below $1130 an ounce Monday morning from its Friday high near $1160, a decline of roughly 2.5 percent.  

We think prices in the $1130 to $1140 range are certainly attractive entry points for long-term investors.  There is good support under these levels from the main Asian markets – China and India – where current prices should engender price-sensitive buying.  In addition, we are at a seasonally important time for the Indian market ahead of the propitious May wedding period.  Bullion traders and jewelry manufacturers stepped up their buying earlier this month – and I expect we'll see still more buying at recent prices.  

Contributing to the anxiety among gold investors was the added news that hedge-fund mogul, John Paulson, was mentioned (though uncharged) in the SEC documentation.  Paulson's hedge funds have been substantial investors in gold, so much so that Paulson & Co. is the largest institutional holder of the SPDR Gold Trust, the largest gold exchange-traded fund (ETF).  My back-of-the-envelope math puts Paulson's total SPDR gold ETF holdings at more than 95 tons.  Gold Investors and traders are reckoning that if investors in Paulson's funds start pulling their money out, Paulson will need to sell gold to cover redemptions.  

Gold's recent strength in the week preceding the Friday sell-off reflected, in part, increased speculative long positions on Comex, the gold futures exchange in New York, and some increase in Western investment into the various gold exchange-traded funds.  Speculative positions on futures markets are certainly not in strong hands – and Friday's news probably generated a good deal of knee-jerk selling by these players.

Don't Rely on Reported Inflation Measures

In my view, the government's consumer price index is seriously flawed and results in a significant underreporting of actual inflation.  Today's actual inflation rate is probably four or five percentage points higher than indicated by the reported monthly CPI.   Not only is inflation now higher than indicated – but even this official data will show inflation accelerating over the next few years.  Recent statistics paint a rosy picture of the U.S. economy emerging from recession with inflation subdued.  Consumer prices, measured by the U.S. consumer price index, are up just about two percent over the past year... and the "core" rate that strips out food and energy is even lower.  I don't know about you, but my family's cost of living has certainly increased by more than indicated by the official consumer price index.  Anyone who does the family grocery shopping, or pays the utility bills, or writes a tuition check for their child's education, or uses public transportation or flies across the country knows the truth about inflation.  

Politicians in this country and around the world love inflation because it is a very effective invisible tax that allows a country to overspend, run large public-sector deficits, and accumulate debt that will eventually be repaid with debased and devalued currency.  

Inflation is a hidden tax that penalizes the working poor and middle class whose incomes as a group never rise as rapidly as the true rate of inflation.  At the same time, inflation pushes all of us into higher tax brackets (known as "bracket creep" by economists), raises the tax take on gasoline and other excise-taxed expenditures, and results in higher local real estate taxes.  

Inflation also penalizes creditors – both institutions and countries – who receive back less in terms of actual purchasing power then they lent.  Woe to those countries – like China or Japan – that have financed America's fiscal deficit and now hold hundreds of billions of dollars in U.S. Treasury debt, debt that is losing buying power.

Right now, inflation is the only politically acceptable method for the United States to dig its way out of today's fiscal mess with trillion-dollar federal deficits pushing total public-sector debt to huge and unmanageable levels.  

In just a few years, a country with annual growth in real gross domestic product around one or two percent and an actual inflation rate of seven or eight percent (a stagflation scenario much like my expectations for the U.S. economy over the next few years) can see its debt go from an unacceptable ratio of sovereign debt to GDP to one that is acceptable and manageable to the debt-rating agencies.

It is easy for the Federal Reserve (or any country's central bank) to raise inflation to accomplish a reduction in the country's debt to GDP ratio.  All it needs to do is just what it has been doing - printing money by purchasing government debt.  

But monetary policy is a blunt tool and there is a high risk that inflation won't top out in mid-single digits when the Fed decides enough is enough.  It is more likely that the central bank will overshoot – and, before we know it, inflation accelerates into double-digit territory.  

Recent inflation measures show year-over-year U.S. consumer price inflation at just over two percent.... and only 1.3 percent for the "core" rate that excludes food and energy on the grounds that these categories are extremely volatile from one month to the next.  Both the Fed and most of the beltway prefer this lower statistic even though in the real world consumers do not have the choice to cut food and energy out of their household budgets.  

A number of factors distort and bias downward the official U.S. consumer price statistics – and mask serious inflation problems already brewing.

  • Official statistics are skewed downward by the imputed cost of housing and the impact of falling home prices.  Most of us – whether we rent or own our homes, apartments, condos, or co-ops – are paying no less in our monthly rents or carrying costs...  but the government accounts for housing costs based largely on the declining "value" of residential housing.  As we've noted, the published CPI data for all goods and services puts today's consumer price inflation rate close to two percent.  But the CPI excluding the imaginary cost of housing is already rising by more than four percent.  
  • Since 1990 the U.S. consumer price index has not been based on a fixed basket of goods and services.  Instead it allows for substitution from more expensive purchases (like sirloin steak) to less expensive purchases (like chopped chuck).  By doing so, it decreases the weighting of goods and services that are rising more rapidly and increases the weighting of those that are rising more slowly or falling.
  • In addition, the CPI is adjusted downward to account for qualitative improvements in the goods and services we purchase.  For example, a mobile telephone last year may have cost $200 and today's standard model may now cost $220 – a ten-percent increase.  But because it has a better screen and longer battery life, government statisticians may judge the improvements to be worth $20 and record the price as unchanged, rather than up ten percent, for the purpose of calculating the CPI.  
  • Consumer prices over the last year or two have also been temporarily depressed by the economy's cyclical inventory adjustments. Many businesses have been living off inventories of raw materials and semi-finished goods bought earlier at lower prices -- and prices of finished goods at retail reflected these lower priced inputs.  In this year's first quarter many businesses began restocking and replenishing inventories at higher prices, higher prices that just recently have begun to be passed on to retailers and consumers.  

Taking these factors out of the calculation of the consumer price index results in a reported inflation rate several percentage points lower than that which actually exists and is felt by consumers.  

Inflation Adjustment for Gold and Silver is Overdue

What does all of this mean for gold and silver prices?  To begin with, we think that there will be an increase in U.S. consumer price inflation beginning sometime in the next few months -- and this is always a plus for precious metals.  But a growing number of investors don't need to see official statistics to know that inflation is already a problem, they recognize it in their daily lives.  

Understanding that inflation is being underreported provides some clues to where gold and silver could conceivably top out in a few years when precious metals reach the top of this price cycle.

Adjusting their January 1980 cyclical peaks of $875 an ounce (for gold) and $50 an ounce (for silver) suggests that inflation-adjusted prices of these metals today would be around $2400 and $140, respectively.  

But adjusting their previous peaks by a measure of inflation that disallows substitution and qualitative improvements implies that gold and silver prices today would be around $7600 and $440 just to keep up with actual inflation.  

I'm not suggesting that precious metals will move to these stratospheric heights, but against this picture my forecast of gold reaching $2000 or possibly $3000 an ounce and silver reaching $60 or possibly much more seems not so unimaginable.  

To arrange an interview with Jeffrey Nichols, please contact Liz Cheek of Hill & Knowlton at (212) 885-0682 or elizabeth.cheek@hillandknowlton.com

About Rosland Capital

Rosland Capital LLC is a leading precious metal asset firm based in Santa Monica, California and buys, sells, and trades all the popular forms of gold, silver, platinum, palladium and other precious metals. Founded in 2008, Rosland Capital strives to educate the public on the benefits of investing in gold bullion, numismatic gold coins, silver, platinum, palladium, and other precious metals. For more information please visit www.roslandcapital.com.

About Jeffrey Nichols

Jeffrey Nichols, Managing Director of American Precious Metals Advisors and Senior Economic Advisor to Rosland Capital, has been a leading precious metals economist for over 25 years. His clients have included central banks, mining companies, national mints, investment funds, trading firms, jewelry manufacturers and others with an interest in precious metals markets.

Contact: Liz Cheek

(212) 885-0682

elizabeth.cheek@hillandknowlton.com



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