As Deflation Looms, What Will Happen to Gold?

Many investors have caught gold fever recently. They're convinced that rampant inflation will soon rear its head as a result of central banks debasing paper currency through excessive money printing.

However, there is no evidence of inflation at this point -- despite near-zero interest rates that keep heading lower as risk-averse money managers pile into Treasury bonds.

As inflation remains dormant, a new threat is emerging: deflation. Big time investors like Bill Gross are talking about the "new normal" being high unemployment and low growth as far as the eye can see. This is pushing the Fed to consider its options. According to The New York Times, last Friday's bad jobs report -- nonfarm payrolls fell by 131,000 in July -- is causing a shift in Fed sentiment from concern about possible inflation to fear of a vicious cycle of falling prices, corporate layoffs, lower pay, and lower demand -- which leads companies to cut prices even more to make up for the slack demand and re-starting the cycle.

The Fed is considering boosting liquidity further through so-called quantitative easing. It might buy mortgage-backed securities, or it could lower the rate of interest it pays banks to hold their $1 trillion in reserves.

Based on all this, will the dollar likely weaken -- boosting gold -- or will the evidence of deflation cause investors to buy dollars as a safe haven and flee gold?

Looking to the Dollar

Lately, the currency markets seem to be interpreting all this as a reason to buy dollars. According to Bloomberg News, gold declined in London for the second day in a row relative to the Euro as investors bought dollars and sold gold.

But this decline doesn't make sense to at least one gold analyst who figures that quantitative easing will add to the money supply and increase the risk of inflation. Park Jong Beom, a broker at Tong Yang Futures Trading Co. in Seoul told Bloomberg, "Worsened employment data may imply the U.S. will maintain expansionary policy a bit longer, which would be supportive for gold. The price will hover around $1,200 an ounce before the Fed meeting."

So should investors buy gold because they, like Park, think quantitative easing means a larger money supply and thus future inflation? Or will the Fed's policy shift to fighting deflation signal that there is absolutely no risk of inflation and therefore buying gold as a hedge makes no sense?

Stairway to Heaven

An investor once told me that if you're a start-up seeking capital, it is better to be losing lots of money than to be making a little. If a company is losing money, it is easier to sell the dream -- or stairway to heaven -- of how profitable the company will be once it gets that capital. Whereas if a company is making a small profit, the investor will conclude that the profit potential of buying stock in that company is limited and will decline to write a check.

Similarly for gold investors, it is far easier to sell the idea that rampant money printing by central banks will lead to out-of-control inflation when there is absolutely no evidence of it. This just shows an obvious fact -- people are irrational and when faced with evidence of their irrationality, they will simply screen out that evidence and grab on to the scraps of data that support the conclusion that they've already reached (I've written often about this so-called confirmation bias).

This means that if you own gold now, you are going to view the Fed's quantitative easing as even more of a reason to buy gold. And if you don't own gold, you'll see the Fed's strategy as further evidence that there is no reason to own gold because inflation is non-existent and is likely to remain so.