Why Deflation is Good News for Gold

Today the U.S. Labor Department released its May Consumer Price Index report, considered a key inflation barometer. There was a 0.2% decline in CPI in May, the largest decline since December 2008's 0.7% decline. The May report also comes on the heels of a 0.1% decline in April. Back-to-back monthly declines in CPI may be a warning signal that deflation is gaining a toehold.

Yet today the price of gold, which in theory should tank in a deflationary environment, is rallying up 1.5% to $1250/oz as I write this. What gives? And how could deflation be good news for gold bulls?


The reason is because the Federal Reserve has been crystal clear in telegraphing how it intends to handle deflation -- by printing more money.

Deflation, as evidenced by the April and May CPI reports, is fueling expectations that the Federal Reserve may substantially expand its already unprecedented money printing campaign.

There are several reasons the Federal Reserve favors inflation over deflation. One is that inflation can help ease the overwhelming debt burden faced by the developed world (U.S., Europe, Japan). Another reason is the specific case of Japan.

The Fed, and Fed policy cheerleaders like Paul Krugman, feel that the Japanese economy has been stuck in a two decade malaise due in part to deflation. Deflation creates an environment where people delay spending on everything from housing, cars, etc. until prices drop further (e.g., why spend $250,000 on that house right now when if you wait a few months the price will be $200,000?)

Put simply, deflation is the enemy of consumption. Deflation creates an incentive to save money. And Ben Bernanke and the Federal Reserve don't want Americans to save money right now because nearly 70% of the U.S. economy is driven by consumption. The Federal Reserve's logic is that consumption must return in order to get the economy started again.

The Federal Reserve has been nothing if not diligent in its printing of money the past two years. Deflation could usher off a Federal Reserve money printing campaign the likes of which the world has never seen before. And that prospect is very bullish for the price of gold.