If you believe, like I do, that inflation is still very much embedded in the financial system then you must also adhere to hard assets, including gold. There’s absolutely no doubt in my mind that we’ll see much higher inflation as a result of this extravagant spending.

In my Commodity Trend Alert (CTA) service, we’ve recently raised our hedges against commodities. I anticipate tough markets for most of the sector until clearer signs emerge that the Fed has arrested deflation.

Still, I’m buying distressed oil companies and oil equipment stocks - and I’m buying oil right along side some of the best positioned global insiders. The energy sector remains the only segment of the marketplace heavily accompanied by net insider buying since prices began dropping in July.

Gold, which FDR confiscated in 1933, would probably rally in a deflationary economy. We got a taste of the huge gold rally to come when gold jumped over a US$100 last week after the AIG rescue.

Also, gold stocks haven’t been this cheap and bombed-out since 2005. In fact, the mining stocks trade at a seven-year low versus physical gold! You should be aggressively buying up this sector now.

Since July, commodity bulls have been trampled during the worst credit crisis in history. The entire complex has gone from being extremely overbought in June to heavily oversold in late September.

In just 30 days, the markets have violently transitioned from concerns about inflation to a sudden panic over deflation. The credit crunch has stopped inter-bank lending and corporate borrowing, leading us to the worst panic in American capitalism since the 1930s.

It’s also resulted in the most indiscriminate commodity sell-off since the bull market began in late 2001. And 2008 might be the first year since 2001 that commodity benchmarks finish in negative territory.

And until the deflation (i.e. the environment of rapidly declining prices) ceases, commodities will remain vulnerable. Never in the history of capitalism have commodity prices rallied during a severe contraction in bank credit.

It’s not just the U.S. anymore. The entire global economy is slowing down. Several countries in Europe and Asia are already either in recession or teetering on the brink of a contraction in output. But there’s one country that’s managed to remain relatively unscathed: China.

Yes, the world’s main driver of commodity consumption this decade continues to grow. That tells me that the recent decline in commodities is way overdone.

Since hitting a peak on July 3, the benchmark Reuters/CRB Index has plunged 25%. All commodities representing this index have declined sharply, including crude oil (32%), gold (22%), copper (22%) and the grains (28%).

China is still one of the more formidable factors supporting raw materials. As commodities have crashed recently, the Chinese are once again hoarding industrial metals like copper, tin, and steel scrap.

The U.S. credit problems won’t stop the Chinese from grabbing commodities - especially when the U.S. dollar inflation-adjusted interest rates are in negative territory. The U.S. Fed Funds currently stands at 2% versus 5.6% inflation through July.

China can’t afford a recession. A major contraction in output would devastate the economy and result in tens of millions of people becoming unemployed. To combat a recession, the Chinese have started to expand credit again after tightening the money-supply since 2006 in small increments. The People’s Bank of China also has the capacity to spend heavily and finance continued expansion.

If you think the Federal Reserve has muscle, think again. China is home to more than US$1.7 trillion in foreign-exchange reserves. They can literally bailout the entire American banking system with one check. They’ll do everything they can to keep this expansion going strong.

Meanwhile, commodities are now heavily oversold. In the span of just 60 days, the world has become obsessed with deflation. Just a few short months ago, inflation fears ruled the markets. That’s a major flip-flop. Commodities are not good deflation-based hedges. Like most assets, commodities decline amid deflation.

In my eyes, the U.S. government has played a big role “talking down” commodities by attacking oil trading speculation. The government blames hedge funds and other speculators for US$147 oil in July. Nonsense.

Was the government helping these same speculators when oil was trading at US$15 back in 1998? Of course not. In an election year, it’s really no surprise the Feds are targeting oil prices. They wanted lower oil prices and they got it.

The macroeconomic picture is also a factor hitting commodities.

The global economy is slowing this fall. Europe is several months behind the United States in this credit squeeze and Japan is basically in recession again. But the emerging markets should get a dose of good news as oil and food prices have plunged by about 25% since July.

These countries, including China, will continue to expand even at the expense of weaker exports. China, India and many other emerging markets are piling billions into domestic infrastructure projects. I’m expecting these and other domestic projects to keep these markets humming until the West can stabilize credit markets.

Commodities are in a brutal correction. We saw similar dramatic pullbacks in 1974-1976 before the sector resumed its historical bull market run to its peak in 1980. It isn’t over yet.