Montreal, Canada

The United States continues to spend like there’s no tomorrow. The Congressional Budget Office, or CBO, projects a record budget deficit of $1.5 trillion in fiscal 2011—up from $1.29 trillion in 2010. This marks the third year in a row of budget deficits totaling more than $3.5 trillion.

Despite some chatter lately to cut spending and Obama’s initiative to reduce the budget deficit (small pocket change), the United States shows no signs of introducing austerity measures, unlike counterparts in Western Europe.

Credit spreads on TIPS, or Treasury Inflation-Protected Securities, continue to show no long-term inflation threat with 10-year TIPS yielding 2.29%; 30-year TIPS show a net yield of 2.56%. But other inflation gauges, like commodities and especially gold, tell a different story.

Combined with the shenanigans at the Federal Reserve, where balance-sheet expansion is in an outright bull market of its own since late 2008, the odds favor a major inflation burst unseen since the 1970s. Slack U.S. industrial capacity; deflation in housing and wages; and sluggish employment growth don’t portend to an inflation problem any time soon, but it’s coming.

Historically, the Fed has done a poor job fighting inflation as depicted by the dollar’s long-term decline and its relative purchasing power vis-à-vis other currencies and gold. The Fed is a lousy inflation-fighter.

Massive government deficits; hugely expensive and unaffordable entitlement programs; and an “out of control” Federal Reserve committed to Quantitative Easing “to infinity” guarantee an inflation fiasco at some point.

And more fuel to the fire seems imminent. A major dislocation occurring at Treasury or municipal bond markets almost assures the Fed will overshoot credit creation and lose control of inflation down the road; the Fed might have to bail out Treasury or/and municipal or state governments.

Indeed, in the absence of any meaningful spending cuts in Washington and deflation attacking state finances, the Fed might be forced to bail out the government one day. The printing presses would head into overdrive. And that would be the nail on the coffin for price stability – if it ever existed in the first place.

The gold bears fail to appreciate the thin line that exists between low inflation and the possibility of an inflation burst. This last occurred in the early 1970s as inflation super-spiked, surprised the markets and resulted in the worst ten-year period for bonds and the dollar since WW II.

Unfortunately for the United States, the next financial crisis won’t be averted because by their very nature a crisis is a Black Swan, or a macro event that shocks and awes the system. The markets will force deficit reduction at some point but at a severe cost to the nation, its citizens and investors in dollar-based assets.

I remain as bullish as ever on gold, oil and other commodities — and especially bullish on volatility.