BEST OF JIM COOK

November 29, 2005

THE DEBT BUBBLE

Richard Russell

Has the Federal Reserve painted itself into a corner by trying to contain inflation with deflationary measures? Newsletter editor Richard Russell sums up how current monetary policies work at cross purposes. "First, the Fed increases interest rates. This puts pressure on the economy, and it will tend to hide monetary inflation. Just as important, rising rates will tend to support the dollar. And to make sure that even the analysts will have trouble uncovering what the Fed is doing -- take away the evidence. The Fed has announced that by next March the broad money supply figure, M-3, will not longer be shown. If you want to hide what you're doing -- it's easy, just bury the evidence.

But there are problems that the Fed can't solve. The Fed is afraid of two phenomena. The first is deflation, and the second is a recession. Increasing the money supply, which is what the Fed is doing, is their way of battling deflation. Raising rates is the Fed's way of slowing the economy and showing that they're fighting inflation.

But there's a problem with boosting interest rates. The Fed knows that there is a limit to how high they can raise rates. At some point they must halt their rate-increases or the economy will roll over and sink into recession. With consumers now carrying over ten trillion in debt, the Fed knows it's been backed into a corner. The American consumer is in no position to deal with steadily rising rates. Hey, US consumers are carrying over 7 trillion in mortgage debt alone.

And here's the key point. The Fed cannot halt its monetary inflation. But as some point ahead, the Fed must halt the rise in interest rates . When that point arrives, the Fed will have to step back and take its chances with inflation. I think that's what gold is beginning to discount. Gold sees the trap that the Fed has set for itself."