By Dan Ferris in the S&A Digest:

Inflation is simple... but not too simple. Inflation is an increase in the supply of money relative to the supply of goods and services. The effect of inflation is usually rising prices of goods and services. Most people confuse the cause with the effect and say inflation is rising prices. That's not true.

Today, we have massive inflation. The total amount of Federal Reserve credit has risen from less than $900 billion as of September 3, 2008, (less than nine months ago) to more than $2.1 trillion as of May 13. Since August 2007, the Federal Reserve has created 12 new lending programs.

But, as the Financial Times reported today, prices fell faster in April than they have at any time since 1955. FT also noted, "The capacity utilisation rate, a measure of the proportion of [manufacturing] plants in use, across all industries fell from 68.1 per cent to 67.9 percent, the lowest level since records began in 1967." It's hard to make a case for inflation with prices falling faster than ever, housing prices still collapsing, and more factories going idle than at any time since record-keeping began 42 years ago.

Yet, we persist in our fears that inflation is the primary risk, not deflation. Gold is at $900 an ounce for a reason, and it's not just because the world has lost its mind. There's a reason why Zhou Xiaochuan, the governor of China's central bank, asked in February of this year, "Is it time for China to consider using the reserves somewhere else, instead of concentrating too much on the United States?" And why Chinese premier Wen Jiabao said in March, "I am a little bit worried. I request the U.S. to maintain its good credit, to honor its promises, and to guarantee the safety of China's assets." And why Luo Ping, of the China Banking Regulatory Commission, said in February, "U.S. Treasuries are the... only option... Once you start issuing $1 trillion-$2 trillion... we know the dollar is going to depreciate, so we hate you guys, but there is nothing much we can do."

A short time ago, it was revealed China had nearly doubled its gold reserves. As John Burbank of Passport Capital put it to us last week in Pasadena, "From a game-theory perspective, China HAS to buy gold."

That means China has only one best move, and buying gold is it.

My friend Vitaliy Katsenelson (author of the excellent book Active Value Investing) said he'd never heard a bullish argument for gold that he liked until he heard Burbank's talk. Vitaliy is one of the smartest, most skeptical, and most rational investors I know. If he was convinced, I'm even more convinced. I respect his intellect that much.

Crux note: Dan Ferris is the editor of Extreme Value. He recently recommended three gold stocks, which he expects to return 300% to 500%. One of the stocks has a "credible, documented" shot at making investors 50 times their money. If you like the idea of owning gold, you should, without a doubt, own these three stocks. They're going to trounce the performance of bullion this year. To learn more about Extreme Value click here...

More posts from Dan Ferris:

Why ExxonMobil is the best oil company in the world

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