“The market exists to discover value,” says gold bug Ed Bugos. Right now, it’s betting on deflation. But Ed says the feds will succeed in reinflating the economy. This means the gold market will shrug off the deflation scare and recover soon. There are three strong reason why the Fed will fail to tighten money supply.

This from Whiskey and Gunpowder:

I think the odds are very low that you will see deflation — outside of a short-term aberration. This is because banks can create money, and there is nothing restricting them from creating all they want.

There is no gold standard today.

Governments got rid of the gold standard so they could inflate without restriction.

Moreover, the central bank has only increased its control of the financial sector over the decades. If we ever had a real deflation (in the monetary aggregates), it would have to be deliberated. That is why the odds are low.

According to the True Money Supply, an Austrian School monetary aggregate, the Fed is currently no tighter than it was in the late ‘60s or mid-‘70s, or even 2000, for that matter.

It is not the 1980, 1990 or 1994 Fed, which was committed to disinflation — and had the public behind it. Nor is it as easy as Greenspan’s post-1996 or post-2001 Fed.

Still, the Fed’s policy could produce a deflation scare if it overshoots in its aim against expectations and allows some deflation in money and credit by some unforeseen accident…or moral hazard.

Such a scenario would probably make the chart right about $695, and boost the dollar.  And this could happen even if we are ultimately right about gold going to $3,000, or higher. It would be temporary, no doubt, Ben would quickly sport his helicopter hat in response.

But there is reason to doubt even a deflation scare.

I am skeptical that the Bernanke Fed will stick to its guns on the money supply for the following reasons:

1. The Fed’s current policy is already net bearish for the “boom” — That is, without money supply growth the “boom” will continue to falter.

2. The political mandate for a tight Fed is weak — In the current economic condition without a forced hand, the Fed will increase money supply.

3. The economy is in no shape for a tightening — At this point the economy is used to cheap money and a tightening of the money supply would cause a “bust” cycle.

However, as long as the Fed can bluff and withstand from increasing the money supply the gold chart will probably be right.

If the bulls cannot hold the Aug. 15 low at about $774 on the front-month Comex contract or recover the $850 handle anytime soon, we’re going to $695, plus or minus, over the next few months.

This risk will dissipate if the bulls can recover $850, especially on a strong dollar. In fact, we have to look back only to 2005 for an example of this bullish scenario. I have already remarked on the similarities in this correction to 2004.

The 2004 correction in the gold sector was the one that occurred ahead of the Fed’s last tightening. Six months after the tightening started, the US dollar began to advance. It advanced all year in 2005.

Likewise, I expect that the gold market will shrug off the deflation scare and recover soon here, as well, ultimately undermining the dollar advance. That is right: The US dollar is the dependent variable, not gold.

It is correct to say that the US dollar is gaining ground on the heels of gold’s correction; it is incorrect to say that gold is weak because the dollar is strong.

Gold is weak because the Fed is targeting it.

But the Fed is bluffing with a bad hand.

Source: The Market Is Always Right