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Note: This commentary was originally posted to Metal
Augmentor on June 15, 2009 at 10:27PM EDT.
Last October, I wrote a commentary called Monetary Base Rocket. In
it, I argued that the liquidity and bailout programs of the Federal Reserve
under the leadership of “Helicopter” Ben Bernanke were the
equivalent of a monetary drop from a proverbial helicopter, but with an
important caveat:
The Fed has added as much to the monetary base in 6
weeks as it has added in any prior 10 year period going back to the early
1980s. Indeed, the rate of increase appears to be about $100 billion every
two weeks and yet the logjam in the credit markets still has not been
cleared.
So, is this the fabled helicopter drop? Yessirreee! There is, however, a slight matter that
deserves some mention. The money dropped from the helicopter has not reached
the ground yet. In other words, most of this money is still being held by the
banks in the form of Reserve Balances. Put another way, it has not yet
started to work its way down through the fractional-reserve lending process
to the credit-strapped private sector.
The reason these funds are being held and not loaned
out by the banks is simple. The Fed is actually paying banks to hold the
funds in reserves. Indeed, the Fed has just today increasing
the rate it is paying by 40 basis points. Some of you may know that the Fed was originally going to start
paying banks for excess Reserve Balances starting in 2011 but the recent
emergency bailout legislation moved that date up so that Reserve Balances
would start to earn interest immediately. The Fed’s intent is to try to
keep the massive increases in Reserve Balances close to the heart so that
these funds serve mainly to shore up the banks’ balance sheets but
don’t create a tsunami of “unnecessary liquidity” in the
money supply. Remember what I said earlier about jumping out of a burning
building. In helicopter lingo, the $300 billion has been dropped but it is
fluttering in midair due to an updraft created by the rotor.
I suspect, however, that the Fed will have to
dispense with its “gradualism” before too long and fly the
helicopter to open airspace in order to avoid a crash. Even if the Fed has no
intention of moving clear, the longer the money stays out there fluttering in
midair, the more difficult it will be to keep it aloft. Moreover, once the
dropped money has cleared the updraft from the helicopter’s rotor, it
can no longer be reclaimed by the Fed without consequences, especially while
the global economy remains on an unsure footing. Thus I suspect most of the
dropped money will eventually flutter to the ground.
What I think we should watch for in particular is an
increase in M1, which includes circulating currency (Federal Reserve Notes)
and demand deposits. The latest data only goes up to October 13, but that
data actually shows weekly average M1 shrinking by as much as $100 billion
since the end of September. If and when we see M1 reverse sharply upwards, we
could start to suspect that the first batches of the monetary drop are
starting to reach the ground and that a “hyperinflationary event”
will not be very far behind. How long could this take? I give it 6 to 18
months although others say it could be literally weeks from now. Jim Sinclair
claims something big will happen in 13 to 88 days, which is the timeframe
between the U.S.
elections and the inauguration of the next President.
The caveat was that the helicopter actually has to
fly clear of the money fluttering in the sky so that it can start falling to
the ground. Much has taken place since I wrote the above piece and several
related ones but the simple fact is that the helicopter has not flown clear.
The money drop continues to be kept aloft primarily because banks are
unwilling to lend their borrowed Reserve Balances as there are no qualified
borrowers who need loans. Also, there is a stigma attached to these borrowed
Reserve Balances. Lending them out means they won’t be paid back
anytime soon, which is a reason of itself not to lend them out. Indeed, some
of the money drop has even been sucked back up. For example, the largest
bailout program, named Term Auction Credit, has seen outstanding balances
drop from $493 billion in early March to $337 billion last week. On a related
front, a number of banks have announced they will be paying back their TARP
money as well.
Be that as it may, the most important development
since my “helicopter” commentaries has been that the Fed has
essentially abandoned the liquidity and bailout programs targeting banks in
favor of a more “traditional” policy move involving open market
purchases of mortgage-backed securities and U.S. Treasury paper. At the same
time, I’ve also mentioned recently in the Dollar & Bond Bottom?
entry that the Fed was targeting the portion of the
Treasury yield curve that is the most supportive to banks. In the last
several weeks, the Federal Reserve has continued to make most of its Treasury
purchases toward the middle of the yield curve which arguably has the best
chance of keeping the entire curve suppressed while assisting the
banks’ borrow-short-and-lend-long policy.
All of the above leads to the observation that I
would like to make today which is that we are NOT seeing a growing rate of
monetary inflation at this point. The Fed and Treasury bailout and liquidity
programs are swimming against a strong deflationary tide created by business
failures, tight credit and consumer entrenchment. Until this logjam breaks,
and it will at some point in the future, the threat of hyperinflation will be
relatively mild. In my earlier post I estimated that it could take 6 to 18
months for a “hyperinflationary event” to take place. Arguably
such an “event” did take place when the Federal Reserve
announced its massive open market securities purchase program but clearly
that will not have an immediate impact.
Based on the current situation, I think it would be
appropriate to change the “6 to 18 months” guess to “12 to
24 months”. And I still expect that the M1 money supply would serve as
a leading indicator of such an event. Alas, we find in the latest Fed
statistics that M1 money supply has increased at an annual pace of just 1.6 percent for the 13 weeks
ended June 1, 2009 on a seasonally adjusted basis compared to March 2, 2009.
Indeed, M1 money supply has essentially been frozen since last December after
climbing rather strongly during the height of the banking panic. It’s
as if deflationary forces are even stronger now despite the “green
shoots” mentality than they were a few months ago when everybody was
peeing in their pants about the global economy being at the edge of an abyss.
In any case, no growth in M1, no monetary inflation regardless of what else
happens.
Yet that has not stopped some people from making
some spectacular (as in spectacularly wrong) statements about inflation. When
facts get in the way, why not make something up? Let’s take the recent
words by “one-handed economist” Howard S. Katz in the commentary Liar, Liar:
According to the June 1, 2009 Federal Reserve
release H-6 (table 3), demand deposits plus other checkable deposits are
equal to $740 billion. But according to the memo this reported figure
is only half of the real deposits. Thus the true number for bank
deposits is $1480 billion. Adding back the missing $740 billion gives
us a money supply of $2.34 trillion (1.6 + .74).
Calculating from end May 2008 to end May 2009, the U.S. money
supply has grown from $1.37 trillion to $2.34 trillion. This is an
increase of 70%.
To put this figure into context, the previous high
one-year growth in U.S.
money supply was 16.9% in 1986. The money supply figures
for the late ‘70s, which gave us a 13.3% rise in the Consumer Price
Index, were in the range of 8%-9% per year.
Here is what this means for the price of gold.
My previous calculation for the price of gold was
$3500/oz. And this was calculated as follows: We are now in an
economic phenomenon I call the commodity pendulum. This means that,
when the Fed creates money, it has an immediate (1-2 year) effect on consumer
goods but a long term (10-20 year) effect on commodities. The commodity
pendulum started in 1963 with the Kennedy tax cut and printing of
money. Over the next 8 years, commodities did not go up and thus became
undervalued in real terms. By 1971, commodities were very
undervalued, and began a 9 year rise from 100 to 337 on the CRB index.
This was the first upswing of the commodity pendulum, and during this time
the rising commodity prices passed through into consumer prices. Thus
for this period (1971-80) the Consumer Price Index rose faster than the money
supply. Then came the second downswing in the
pendulum (1980-1999), in which commodities got even more undervalued than in
1971. This was why Reagan and Bush, Sr. were able to print so much
money with only a small effect on consumer prices. The decline in
commodities was undercutting the rise in consumer prices and making it
smaller. Now we are in the second upswing in the commodity
pendulum. It started in 1999/2001 and I estimate that it will run for
about 20 years.
Unfortunately for this gold price prediction, Mr.
Katz is incorrect to assume that swept deposit balances are time deposits and
therefore not counted in “the U.S. money supply”. He
states:
This process of reclassifying bank demand deposits
as time deposits is the fraudulent part of the new procedure.
Some demand deposits are in fact swept to savings
deposits (a component of M2 which is part of “the U.S. money
supply”) and they have been swept for
a long time, not just the past
year. By excluding the swept amount from the $1.37 billion balance of M1 in
May 2008, Mr. Katz makes it appear as if there has been a great amount of
monetary inflation during the past 12 months. There has not. Moreover, if the
deposit sweeps themselves were concealing monetary inflation in M1, it would
still show up in M2. The growth of M2 over the past 12 months, however, has
been 9 percent on a seasonally-adjusted basis. That’s high but by no means hyperinflationary.
So, we remain on hyperinflation watch, forced to
guess like everybody else (if and) when the initial “event” will
take place. Given the widespread and severe nature of the economic crisis,
any guess (including our own) is going to be a shot in the dark. And while
such a guess might be an acceptable basis for speculation, it should not be
used for determining the timing of a whole-portfolio investment allocation.
By that we mean a “fully-loaded buy-and-hold” strategy involving
gold and/or silver is way too defensive, presumptive and will not be as
profitable as Mr. Katz and many others would have you believe.
We prefer a strategy consisting of a core position
of physical gold and silver bullion held in your own secure possession and
perhaps a few mining equities that are buy-and-hold with the remainder of the
portfolio being traded on the basis of market fundamentals and technicals. An allocation to core physical gold and
silver bullion of at least 10% is warranted in the current environment. The
portion allocated to mining equities and trading positions will vary on risk
tolerance, age to retirement, income and other factors that each individual should
carefully weigh, with the assistance of a professional if needed.
Tom Szabo
Silveraxis.com
Also by Tom
Szabo
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