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If You Come to San Francisco...

By Jon Nadler       Printer Friendly Version
Nov 28 2008 9:16AM

Good Morning,

Post-holiday trading saw mixed markets this morning, as those participants who did return to work continued to roll positions into February contracts and cleaned up logbooks. November was kind to gold as it marked its best gain in decades, following the opposite scenario having just taken place in October. The metal is trading at virtually the same levels as one year ago but is doing so against the background of a vastly changed (and not for the better) financial and economic landscape.

Topping this morning's news, the devastating attacks in India have added a new dimension to global jitters - one reminiscent of the conditions that kept investors reaching for safety following Mrs. Bhutto's assassination nearly one year ago. Adding to angst, Japan's contraction deepened while consumers cut back on spending and as factory output cratered. Over in Europe, inflation threats receded at the fastest pace in twenty years and underscored the pattern of global disinflation we are experiencing. Russia had to raise rates for a second time this month as the ruble lay flat on its back, abandoned by investors and damaged by inflation.

New York bullion prices opened mixed, and evidence of thinly traded conditions was manifest at the start. Risk aversion was being sensed again, as the dollar rose to 86.45 on the index and as oil prices fell back to under $54 per barrel. Stock futures showed a negative bias following the Mumbai attacks, and today's focus will likely stay on retailers (Black Friday turning out red remains a worry) and on geopolitics. Not much in the way of economic stats to try to trade on.

Gold opened with a $6 gain at $812 per ounce, and players were already looking ahead at the weekend OPEC meeting for fresh direction. Indications are that they may not get and output verdict from the cartel until next month. Silver lost 16 cents to open at $10.11 per ounce. Platinum fell $4 to $858 while palladium dropped $6 to $185 per ounce.

Almost all of the talk about disinflation turning into deflation falls into the scary/depressing/to-be-avoided-like-the-plague category. Japan does not appear to be too worried about such prospects. Again.

Bloomberg's William Pesek finds that while we might have valid reasons to fear such trends -especially as we normally associate them with images of soup-kitchen lines, some of the realities inherent in the process might contain the seeds of the next era of good times:

"Deflation is destined to make an untimely return to Japan.

The second-biggest economy faces the most acute threat of falling prices among industrialized nations, the Organization for Economic Cooperation and Development said on Nov. 25. Sound gloomy? The OECD may be overly optimistic to think deflation won’t reemerge until the second half of 2009. Things aren’t as dire as they seem. In fact, a return of deflation may offer benefits to Japan’s outlook. That also could go for other developed nations experiencing mild price drops. Japan’s latest inflation figures will be released tomorrow.

Deflation was the unheralded catalyst behind the restructuring that fueled Japan’s longest postwar recovery. Officials in Tokyo have been quick to blame the U.S. credit crisis for Japan’s recession. An explanation that deserves equal weight is that the positive side effects of deflation didn’t have enough time to assert themselves. To make such an argument is to delve into the territory of economic heresy. It’s true that falling prices are rarely, if ever, good for the broader economy. They are a nightmare for debt holders and property owners. They can hurt corporate profits, cut wages and eat into government tax revenue.

Yet Japan benefited from deflation in two ways. First, it offered a kind of stealth tax cut for consumers, who gained more purchasing power between the late 1990s and mid 2000s. Second, it forced major change in the bloated, inefficient economy. China’s rise was among the forces that prompted Japanese executives once and for all to restructure. Companies streamlined a labyrinthine distribution system that involved many middlemen and inflated prices. Banks also realized in the early 2000s that they couldn’t grow their way to health. They stepped up efforts to dispose of bad loans.

There’s a reason, though, why Japan’s political and corporate establishments were so frightened by deflation and obsessed about ending it. It was an uncertain and destabilizing force they couldn’t control or understand. Policy makers wasted several years acting as if deflation was the cause, not a symptom, of Japan’s malaise. It was more about a malfunctioning credit system and increased global competitiveness. Whether officials know it or not, Japan’s growth in recent years owes much to deflation.

The return of inflation, albeit mild price increases, in recent years prompted the popping of champagne corks from Tokyo to Washington. It also took pressure off the government to continue efforts to modernize the economy. As deflation threatens to make a comeback, officials in Japan and elsewhere need not panic. The key is to keep the trend modest. Aggressive drops in consumer prices won’t help business or investment confidence. And they certainly wouldn’t bode well for stock markets.

Like it or not, falling prices are something with which governments around the globe will need to grapple. Hungary, Iceland, Ireland, Spain and Turkey will experience “severe? economic declines, many because of housing slumps that “still have a long way to go,? the OECD said. It added that deflation has become a greater risk than inflation. Deflation in China is certainly a threat if the global crisis gets worse. In Japan, Taro Aso certainly won’t appreciate being remembered as the prime minister who oversaw the return of deflation. And yet he’s taking very doctrinaire steps to stabilize growth, like fiscal pump priming.

Lacking in Tokyo these past couple of years has been long- term planning to prepare for an aging population and boost entrepreneurship. The Bank of Japan also is reluctant to take more drastic steps to fight deflation -- such as returning interest rates to zero from today’s 0.3 percent. The world is changing faster than Japan’s policy makers can adjust. The return of deflation will make it harder to remove structural impediments to growth with lax monetary and fiscal policies or a weak currency. Such measures offer short-term gains at the expense of long-term prosperity.

The good news is that Japan’s deflation didn’t turn into the global nightmare the U.S. feared. In October 2002, for example, Nikkei English News reported that the Central Intelligence Agency was investigating the effects of Japan’s deflation. It had all the makings of a Tom Clancy novel and showed just how concerned the U.S. was about the dynamic hurting American consumers. Now, of course, economists are left wondering if the U.S. is headed toward deflation.

Japan is the more immediate risk. The BOJ didn’t formally end its deflation-fighting policy of pumping extra cash into the economy until March 2006. It’s worth noting that it took record increases in oil and food prices to produce a bit of inflation. Now, “there is a high probability that Japan’s economy will slip into deflation in the third quarter of 2009? as core consumer prices turn negative, says Kyohei Morita, chief economist at Barclays Capital in Tokyo.

It could happen sooner if the global outlook turns even gloomier in the months ahead. While not good news for Japan’s leaders, history shows that may not be the disaster it seems."

Housekeeping notes: We now head over to San Francisco, for the Hard Assets Conference - at which, we invite you to stop by our booth, for some fine surprises and contests. you will find all the relevant details here. Hope to see you there!

After that, it' the looong trek to Shanghai, for the 3rd Annual China Gold Summit and a bunch of other meetings. Thus, next week's posts might be a little...sporadic, but we trust they will contain items of interest direct from the country that is the source of all kinds of global attention.

Pleasant weekend!

Jon Nadler
Senior Analyst
Kitco Bullion Dealers Montreal



Disclaimer: The views expressed in this article are those of the author and may not reflect those of Kitco Inc. The author has made every effort to ensure accuracy of information provided; however, neither Kitco Inc. nor the author can guarantee such accuracy. This article is strictly for informational purposes only. It is not a solicitation to make any exchange in precious metal products, commodities, securities or other financial instruments. Kitco Inc. and the author of this article do not accept culpability for losses and/ or damages arising from the use of this publication.