In our comments a few weeks ago we went off on a tirade about the lack of coverage of Gold in the popular media. We have found no reason to change our view of the dismal work being done by journalists, generally speaking that is as some do try to rise above the pack. In particular we read one over the past weekend, in a very respected business magazine, that lamented the possibility of Gold doing well. The author thought that would be a shame as Gold is boring. Hey clod, investing is not about excitement. Excitement was JDSU and TYC. Investment is about getting your principal back along with some return on that principal.

The whole matter gives one headaches. But as so many responded after the last commentary as long as the popular media is still talking about INTC or CSCO or ORCL or whatever, our positive attitude toward Gold is safe as can be. What is really baffling is not that so many investment people do not understand Gold, but that they still keep their jobs owning things like TYC. Totally baffling.

Like many we get insecure some mornings, but then we pick up the paper. This past week The Wall Street journal had an article, "Was That the End of the Gold-Price Rally?" The author seemed to imply that Gold investors were worried after the small correction of that week. Personally, worry should not have been a concern that day. Later in the article an economist for a prominent brokerage firm was quoted as not understanding the positive move of Gold. No words could be ever more reassuring. If a Wall Street economist ever started understanding Gold, or anything else, we will have some real concerns.

This was to be the second in a two-part series. However, after thinking about it this will be the second in a three part series. The reason for that is we want to talk about inflation and the potential of that force to aid the price of Gold. Inflation is to be a special situation this time, being driven by currency devaluation.

Inflation results from creating more money than people want to hold as money. If the central bank produces more money than people want to hold then two things can happen. One, they might get rid of those dollars by buying "something" which would push up the price of "somethings". Such is the inflation process of which we traditionally think. However, a second possibility does exist.

If the Federal Reserve produces more dollars than people in the world want, those dollars will be sold in the foreign exchange market. That selling of dollars and buying of another currency will push down the purchasing power of the dollar. The price of "somethings" in the U.S. would therefore rise. Such is the type of inflation the U.S. is more likely to experience in the period ahead. Global financial markets will be a unique influence on the future inflation environment.

Currency values are the issue. For example, inflation has burst forth in Argentina, 18+% in the past year, as a result of that nation's currency problems. U.S. inflation has appeared to be tame as the dollar has not yet come under serious attack. However, the Gold market and the foreign currency markets are starting to suggest that the purchasing power of the dollar is in trouble. That means that inflation in the U.S. is likely to accelerate in the future.

Space precludes a thorough discussion of inflation. First, inflation is not defined by the consumer price index produced by the government. Second, inflation is a concern not only because of the impact on the consumers' purchasing power. Inflation distorts the investment process. Just as bad as "inflation" are price bubbles as we witnessed in the U.S. stock market and the Great Greenspan Housing Bubble now building toward termination.

If one reads the laws giving guidance to the Federal Reserve no where will be found that one of the goal's of the Fed is to be control of the consumer price index(CPI). Price stability is the assigned goal. That means that price bubbles in financial assets should be avoided. That means that price bubbles in housing should be avoided. The Federal Reserve has no legal mandate that blesses the creation of financial bubbles.

Unfortunately, we need to move on. Let us do so by considering the graph titled, "Inflation Measures." Two measures of inflation are included in the graph.

The first of those measures is what we refer to as the "Naive CPI," and is the thin line in the graph. We give it that name cause anyone that truly believes a government number is naive. The second measure is a much better indication of the central tendency of inflation. The talented elves at the Federal Reserve Bank of Cleveland produce each month a "Median CPI," and is the bold line. This data and an explanation can be found on their web site. (For a discussion of this matter see "$1245 GOLD.")

The Median CPI is a better measure of the entral tendency for inflation. We will go into this more in the next article as we want to set the stage here. The Median CPI as can be seen in the graph is running just off the highest level since the early 1990's. On a year-to-year basis this measure indicates that inflation is about 3.7%. The Naive CPI, used by the Federal Reserve for decision making, is up 1.6% on a year-to-year basis. The better measure of inflation, the Median CPI, is more than twice the rate indicated by the government statistic used by Federal Reserve to set monetary policy.

This Median CPI has another use. We can use it to create buy and sell signal on the Naive CPI. This is done by using the simple difference between the two measures. When the difference between the Median CPI and the Naive CPI gets too large the tendency is for Naive CPI to change directions . We have plotted those signals in the graph with triangles. The danger in this situation will be explained in the next article.

Now let us go an interesting step forward by plotting those signals along with the monthly average price of Gold. This has been done in the next graph. An interesting picture develops.

Since most of us are interested in how we invest let us focus on refining the use of these signals. For that purpose we will consider only the first signal in a series that is a change from the previous signal. What this means is that in March 1978 we got the first buy signal on inflation since the previous sell. Then we use the first sell signal that develops next for our signal to sell.

If one had bought Gold in March 1978 and held till recent times, a gain of about $126 would have been achieved. If one had used the first buy/sell signals, the gain would have been about $386. The first signals produced a gain three times as large as buying and holding.

In the spirit of disclosure, the last first buy signal was in October 1998 at a monthly average price of $296. While certainly we would have all liked to buy at the 1999 bottom, few of us did. In any event, that signal is profitable and still in control. And we might add, that signal is a whole lot better advice than we got on the cable shows.

As the end of this effort is slowly approaching, let us summarize. The next bout of inflation in the U.S. will be a result of currency problems as being experienced in Argentina. The Federal Reserve uses the Naive CPI for decision making, a problem we will discuss in the next article. Using the Median CPI and Naive CPI we can develop buy and sell signals on the Naive CPI. These signals are useful in the timing of Gold purchases. The last signal on U.S. inflation is a buy signal. The last inflation signal on Gold was a buy.

As the Federal Reserve sets monetary policy based on the Naive CPI, a reversal in that measure as is likely will probably cause a change in policy. As the Naive CPI is likely to move higher we can expect monetary policy to move in a way that will pop the Greenspan Housing/Mortgage Bubble, damaging the illusion of growth in the U.S. economy. The U.S. dollar will be adversely impacted and Gold will benefit.

And finally, an important note. Today's inflation rate is never tomorrow's inflation rate. Pick any point on the graph for a test. Is the inflation rate a year later the same as at that point? No, of course not. That is an important lesson not learned by economists and strategists at Bay and Wall Street or the Federal Reserve.

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Ned W. Schmidt,CFA,CEBS publishes THE VALUE VIEW GOLD REPORT, a monthly review of the developing Gold Super Cycle. His major report, “$1,245 GOLD”, 150+ pages with 70 charts and graphs, is essential reading for investors wanting to understand the coming Gold Super Cycle. As a special offer "$1,245 GOLD" is available for $45.

This report can be ordered by contacting Ned at nwschmidt@earthlink.net
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