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Observation
following a tumultuous political summer season: the time honored pattern of a
summer correction in the gold price has been broken. Over the last seven
years, gold has followed the seasonal buying patterns of China and India.
Accordingly, gold prices increase from higher demand beginning in late summer
continuing through early spring of the following year, and remain flat or
decline until the cycle is repeated.
The
gold price actually increased during the late spring and summer months, and
is now receiving wider attention from the financial media since it crossed
the US$1,000 level. This would suggest that something is superseding the
customary seasonal pattern of gold prices. This was not altogether unexpected
by anyone paying attention to actions by the Federal Reserve to boost
liquidity in the wake of the meltdown of the financial markets in the fall of
2008. The Fed has since taken extraordinary measures to increase liquidity in
order to offset the collapse in both supply and demand for credit.
The
Role of the Federal Reserve
The
Fed has had limited success in averting crises by increasing liquidity in
recent history. Liquidity was increased in anticipation of potential
disruptions affecting information systems when the millennial clock struck on
Y2K and in the wake of the September 11 terrorist attacks on the World Trade
Center in New York City. When confidence of the markets resumed, excess
liquidity was drained from the economy in time to avert long-term damage from
inflation. With ballooning deficits, one can only wonder when too much
liquidity may irreparably harm the economy.
Reported
inflation and equity markets in the U.S. appear to be at the mercy of the
Fed’s open market activities increasing or contracting the money
supply. The volatility of the Dow and metal prices appear correlated with Fed
actions through 2009. Fed Chairman Ben Bernanke wrote his doctoral
dissertation on the Great Depression of the 1930s. His thinking is
unlikely to stray from the observation that tight money deepened the crisis,
and he is unlikely to allow markets to slip into or remain in a
“liquidity trap.” As the goal of the Fed is to move the
economy toward “full employment,” with Bernanke’s finger on
the monetary trigger, the target of both full employment and stable money is
becoming harder to hit as it moves further into the distance.
Dusting
Off Irving Fisher’s Equation of Exchange
To
understand Bernanke’s dilemma, Irving Fisher’s Equation of
Exchange may provide some helpful insights. The Equation of Exchange is M
times V equals P times Q (MV=PQ), where M signifies the current supply of
money and V signifies velocity, or the rate at which money circulates through
the economy. The product of M and V quite simply must equal Q, or output,
which is the sum of all goods and services transacted in the economy adjusted
for the price of money, signified as P.
Early
on it was believed that velocity (V) was constant, but recent experience has
shown this to be incorrect, as banks as well as consumers have cut back on
lending and spending, while both hoard cash due to decreased financial
visibility. The two primary schools of thought weighing in on Fisher are the
Keynesians and the Monetarists. The Keynesians correctly recognize the
volatility of velocity, but believe deficits and monetary stimulus are
essential for avoiding the liquidity trap which may have existed in the Great
Depression. Milton Friedman, the dean of the Monetarist school, while early
on was incorrect in assuming velocity to be constant, quite correctly
recognized that “inflation is always and everywhere a monetary
phenomenon,” and gold is the time honored hedge against
inflation.
Understanding
Divergent School’s of Thought May Provide Understanding
The
two schools of thought seem to agree on this point but have nearly opposite
views on the subject as it relates to the role of money and the mission of
the Fed. The current administration and managers of the Fed act in
alignment with the Keynesians. Quite certain in their own abilities, they act
with complete confidence that they can cure all the ills in the economy
(eliminate “unfairness”) with open market policies. Given the
extraordinary events and direction of the administration, this self-assurance
appears to border on hubris.
It is
generally accepted that, due to the lags in affecting monetary policy, it may
take six to eighteen months for the full impact of an action to be
recognized. There are simply too many variables and unintended consequences
that must be anticipated. In addition, in the current global economy,
the U.S. is now a competitor for capital as well as goods and services, the
U.S. economy is no longer a closed system, and the Fed is no longer the
master of the world economy.
The
Monetarists, lacking the current limelight of the financial media, no doubt
remain optimistic in the ability of individuals to make their own intelligent
financial decisions. While Monetarists would likely have gone along with
a short term infusion of liquidity, it is questionable that they would have
supported excessive government intrusion into commerce (banks, auto industry,
energy, healthcare, etc.).
Certainly,
under the Monetarist’s optimistic vision of free markets, the cycles
would be more intense, but by allowing inefficient operators to retire, the
lifted burden from the economy would have allowed the upward advance of
wealth for all members of the economy to continue. In any event,
Friedman believed that a stable but growing money supply able to meet the
long-term demand for liquidity would be critical to support a growing and
efficient economy, or “full employment.”
The
Equation of Exchange Demands Either an Increase in Production or Inflation
Fisher’s
Equation of Exchange, while helpful in understanding the events of the last
twelve months, may now provide a clue to the next twelve months. The present
situation may be summarized as excess growth in the money supply offsetting
slower circulation of cash while excess capacity (unemployment) in the
economy absorbs inflation. The U.S. Dollar, while weakening, remains
reasonably resilient as the U.S. continues as one of the world’s most
stable economies (for the time being).
As
velocity reverts to the mean, liquidity may emerge either in a growing
economy or higher prices with potentially rapidly increasing inflation.
Depending on how quickly the economy responds, and influenced by the election
cycle, Bernanke will be at a crossroads. Having concluded a Faustian bargain
by preserving excess liquidity in the economy, Bernanke has assured his own
reappointment, career, and desired legacy as having avoided a second Great
Depression. How will Bernanke know when to pull liquidity out of the economy
and how much is enough? He may be in the unfortunate position of having fewer
tools at his disposal to remedy the situation without upsetting a recovery.
From
a Supply Side perspective, promoting an environment friendly to expansion of
production of goods and services (Q) may increase visibility and allow money
to more freely circulate, absorbing both excess money supply and taking the
wind out of inflation. This would require a national policy promoting
efficient markets through non-intrusive government activity, such as reducing
taxes on the most productive elements of society and pulling back on
intrusive non-productive regulations. This was the policy in the early years
of the Reagan administration, and growth exploded while inflation remained
caged. This proved that economic growth and low inflation may occur
simultaneously. Optimistically, this provides a course out of the current
situation, but given the current administration’s policies, optimism
and reality are at odds.
The
government priority of exerting control over the economy appears more attuned
to political careerism than improving the plight of the poor. As inflation
pushes more people into higher tax brackets, more “rich” will be
manufactured and the tax burden will move deeper into the middle class. This
will confirm Friedman’s maxim that “inflation is a tax without
legislation.” The erosion of the middle and entrepreneurial class
in the U.S. may, unfortunately, help the government reach its goal of
redistribution and equality.
The
U.S. is now competing in a global economy. Other nations and their
populations, including China and India, become more desirous of holding hard
assets and precious metals as a store of value as opposed to U.S. debt and
other U.S. denominated securities. A slowing economy will erode the
U.S.’s security and leadership role in the world.
Theory
and Reality May Intersect in the Next Twelve Months
The
current situation may provide a good case for rapid inflation and exuberance
in the price of precious metals fueling yet another bubble within the next
twelve months. This may produce an opportunity for traders with close
connections and insights of Fed action. In general, one may anticipate
that the seasonal factors of increased demand for gold will soften at higher
price levels, with the balance absorbed in investment, as less valuable
currencies are traded for gold.
While
most economists see a rebounding U.S. economy in mid-2010, it is conceivable
that if commodity prices increase rapidly, Bernanke may raid and recapture
excess liquidity early in 2010. If this coincides with falling seasonal
demand in early 2010, commodity prices and metals and mining stocks may be
subject to a significant correction, or buying opportunity, depending how you
look at it.
Beyond
focusing on careers, the priority of the Fed is to maintain “full
employment.” Clearly, as reported unemployment inches toward 10%,
(while understating actual unemployment, or excess labor capacity, is
possibly in the high teens), inflation is not yet a pressing concern. This
perspective may encourage the Fed to continue easy money policies until it
loses its nerve. Clearly, more money with fewer goods produced is
inflationary, consistent with Friedman’s maxim on inflation, making
gold attractive until the Fed pulls back.
An
ideal perfect storm is forming for inflation, and the Fed may have difficulty
implementing the appropriate remedy at exactly the right time. The volatility
may actually favor longer-term investors invested in precious metal
producers, or lucky traders weathering dilution in precious metal exploration
stocks. Until the liquidity tide pulls back, and seasonal buying
recedes, gold and precious metal stocks may see increased demand.
Important for investors, the direction of gold over the next twelve months
may again supersede or exacerbate past seasonal patterns, quite possibly due
to unforeseen and unpredictable actions by the Fed.
Mike Niehuser
Beacon Rock Research.com
Mike Niehuser is the founder of Beacon
Rock Research, LLC which produces research for an institutional audience and
focuses on precious, base and industrial metals, and substitutes, oil and
gas, alternative energy, as well as communications and human resources. Mr.
Niehuser was nominated to BrainstormNW magazine's list of the region's top
financial professionals in 2007.
Mr. Niehuser was
previously a senior equity analyst with the Robins Group where he was a
generalist and focused on special situations. Previously he was an equity
analyst with The RedChip Review where he initially followed bank stocks but
expanded to a diverse industry range from heavy industry to Internet and
technology companies.
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