Is Dr Bernanke right on oil and inflation?

This correspondent is writing from Sydney Australia on his first visit for a decade. If inflation is under control why then are prices twice the level of 10 years ago, and house prices three times higher? Is that not inflation?

It certainly feels like inflation by any other name. Dr Bernanke seems to be wrong when he said this week: 'The sharp increases in energy prices over the past few years have not led to either persistent inflation or to a recession, in contrast to the US experience of the 1970s'.

For we have seen rampant asset price inflation and the US housing sector is in a slump and the US auto industry. Now will the situation in the US get better or worse? The signs are not that good. The ongoing sub-prime mortgage crisis continues to unwind threatening a further tightening of credit.

Debt mountain

But it is the mushrooming of debt that should really be worrying people. The Australian BRW business magazine last week pointed out that derivative related finance now stands at more than 800 per cent of global GDP and represents 75 per cent of global debt. This is the massive leveraging of financial instruments that could produce a 1929 meltdown in global financial markets.

Now if this debt overhang has to be fixed what will Dr Bernanke do? He is a student of the Great Depression of the 1930s which followed the debt driven share trading boom of the 1920s. So he is unlikely to adopt the deflationary policies of that time.

That leaves inflation, lower interest rates and a devalued US dollar. Indeed, it is arguable that the only way to deal with the derivative debt mountain is to let inflation rip as inflation erodes the real value of debt with rising general price levels.

Back to the 70s

Resource prices like oil would inflate well beyond current price ranges under such circumstances, just like in the 1970s. But that was not a good time for stock markets as inflation hit corporate profits with rising input costs, real estate slumped and then drifted upwards and those on the fixed income of bonds were really stuck.

Hence energy and resource related financial assets like oil company shares, and precious metals would likely be the best investments in such a scenario. Whatever Dr Bernanke says this looks the direction in which the US and global economy is heading.

The next step should be a stock market crash which would rally the US dollar followed by much lower interest rates which would devalue the greenback. Thereafter inflation would sort out global debt levels and rebalance the world economy.

But most investors are invested for precisely the reverse scenario and so will suffer badly.