Gold is trading above $1900/oz once again, pushed up by continuing financial turmoil in the Eurozone, weak US economic data and strong words from a voting member of the FOMC who reiterated his conviction that the Fed should continue its large scale monetary stimulus policies.
Chicago Federal Reserve Bank president
Charles Evans told a CNBC interviewer that “We need to do much more to increase the level of
accommodation.” But Fed Chairman Bernanke
did not announce a new policy at the annual Fed conference at Jackson Hole, Wyoming.
In fact, the Chairman’s
speech was underwhelming.
The Fed is out of bullets,
and Chairman Ben knows it.
Certainly, the Fed has very
powerful monetary tools at its
disposal. The Fed can set
interest rates that banks charge each other for short term
transactions, which influences the shape of the yield curve. Lower interest costs usually spur investment. The Fed can also provide liquidity to the general economy by buying US Treasury bonds and other long term fixed assets
(Quantitative Easing). The Fed and most Keynesian economists believe Quantitative
Easing can stimulate the economy in the same way Federal
spending adds to aggregate demand. These monetarists believe that by adding Fed credit to member banks, more money becomes available to lend, demand deposits expand, along with economic
activity. Since the financial meltdown of 2008, the
Fed has maintained near-zero
interest rates and added
$2.3 Trillion in monetary stimulus credit. Despite these massive stimulus measures,
2nd quarter US GDP growth has slowed
to 1.0% (and 1st quarter GDP has been revised down
to 0.4%) while the unemployment
remains above 9%. Zero net new jobs were added in August.
John Maynard Keynes attributed the deterioration of
economic conditions despite
stimulus measures to the “liquidity
trap.” According to
Keynes, this is the
condition in which real interest
rates cannot be reduced by any action of the
central bank. The real interest
rate cannot be reduced beyond the point at which the nominal interest rate falls to zero, however much the money supply is increased. The trap occurs when
central planners are unable
to promote investment by cutting real interest rates, even when rates are near-zero. Paul Krugman, the
Princeton economist, believes
that 70% of the world’s
economies are in a liquidity
We have seen this play out in recent history; the Fed should study what occurred in Japan. In 1991, the Bank of Japan hiked rates suddenly, bursting the speculative real estate and
stock market bubble created by nearly twenty years of easy money. After asset values dropped by more than 60%, the Bank of Japan slashed rates to near-zero and implemented massive quantitative easing,
setting up a classic liquidity
trap. From 2001 to 2006
the Bank of Japan increased
the monetary base by over 70 per cent. Japan’s economy ground to a halt and unemployment spiked.
Stagflation took hold.
The effects of the bubble's
collapse lasted for more than
a decade with stock prices bottoming in 2003. Japan’s “Lost Decade” is the direct result of central
bank intervention and misguided
We know that increasing the money supply, in
any interest rate environment, devalues currency in circulation. More money chasing
the same assets drives prices up. Increased economic activity combined with declining real output can produce hyperinflation, as we
have seen in extreme
cases such as Weimar Germany, Argentina and
Zimbabwe. Conversely, contractions in the money
stock push prices (and wages)
down. In the 1930’s the Fed reduced the money
supply by 30% which deepened and extended the Great
To combat the current
recession, the Fed has adopted
a near-zero interest rate
stance and injected trillions into
the economy by purchasing
US Treasury bonds and other
fixed income securities, while extended unprecedented levels of Fed credit to member banks. Rather than turn
the economy around, these measures have weakened the US Dollar and pushed
prices up at the producer and the consumer levels. The CRB index, a broad measure of commodity prices climbed over 45% since the Fed made its first
trillion dollar credit injection, then jumped another
35% after the Fed added
$600 Billion to the money supply through it second round of
Quantitative Easing (QE2). Since
QE2 took effect, the US
Dollar has dropped nearly
16% in value.
rates usually help stocks. But equities
have become quite
volatile as nervous traders quickly
sell on any hint of bad economic
news, and rush in to buy on any
whiff of positive data, hoping
to have finally found the
bottom. As of today, the
Dow is down 4.59% year-to-date
and the S&P 500 is down 8.33% year-to-date. Treasury yields are at record lows, which are pushing fixed income investors out to the
long end of the yield curve.
After inflation and taxes, this
asset class is underwater, too.
have turned to gold in the safe-haven
trade. Gold has gained
38% year-to-date and 52% over the last 12 months. While the US Dollar has
declined, some analysts believe gold could become a shadow currency against which all other currencies are evaluated as the world monetary
base expands. Central banks
around the world have become
net buyers of gold bullion.
J P Morgan Chase is now accepting gold as collateral
for client accounts. And retail
investors are pouring into gold as the means to diversify their holdings and hedge against economic uncertainty. It wasn’t long ago that $1000/oz gold was considered unthinkable. Today $2000/oz
gold is within reach.
It is not likely that Washington will pivot abruptly away from its
current economic azimuth. Wall Street is hoping for QE3, and it may get its
wish. Gold and silver prices are telling us that the Fed will continue its near-zero interest regimen and will likely expand
its bloated balance sheet in some novel and debilitating way, yet.
The simple truth
is new government spending and more monetary
expansion, even in the name
of job creation, will not
add permanent private sector jobs. More government spending only comes from higher
taxes, more federal borrowing
and the printing more paper money out of thin air. Every dollar of government spending comes out of the pockets of its citizens, which reduces economic activity. As we know from Proudhon, “Property is theft.”
If higher taxes don’t
ruin us all, inflation will.
So prudent investors
must continue to act to defend
their private property and protect their wealth. Investing in gold, the true sound money, is the way.
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