Monetary Policy, Competitive Devaluation, Inflation. . .
Source: Jeffrey Nichols, NicholsOnGold (10/7/10)
"And the future price of gold."
The U.S. dollar price of gold is now up more than 20% this year and looks certain to score its tenth consecutive annual increase in a decade. By comparison, U.S. equities, measured by the Dow Jones Industrial Average or S&P 500, are up a meager 4%–5% year to date (YTD).
No Bubble Here
Notably, the yellow metal's recent advance does not look like a developing bubble or feeding frenzy driven largely by institutional traders and speculators operating in derivative markets. While they have played a role, the price surge owes more to geographically diverse physical demand by the whole gamut of investors—from small-scale retail buyers of bullion coins and bars to large-scale funds acquiring physical gold directly and through gold ETFs.
And, so far, we have not seen a sizable reverse flow of old scrap (secondary supply) from profit-takers in the price-sensitive markets of India, Turkey and the Middle East—what my good friend Tim Green, gold historian and author of The Ages of Gold, calls "the mood of the souks." The mood of the souks, whether they're buying or selling, is often a good predictor of imminent price developments. So far, the mood remains somewhat constructive—but history suggests this can change very quickly.
Caution remains essential. Gold prices rarely move straight up. When they do, you can be sure of an imminent reversal. Indeed, I expect significant two-way volatility will continue to characterize gold's upward march with big declines leading some to prematurely announce the end of gold's bull market.
A swift drop back down below the $1,300/oz. level—or even lower—without a dramatic and unlikely reversal in gold's bullish fundamentals would not diminish my enthusiasm or cause me to alter my long-term forecast of $2,000/oz. gold, followed by $3,000—and possibly much higher in the next few years.
As I have stressed in past reports and speeches, gold's ascent reflects many factors. Among these are: Growing jewelry and investment demand from China, India and other emerging economies; the rise of gold as an "asset class" and unprecedented institutional investment demand; the new "gold-investment infrastructure" that makes gold more readily accessible to more investors around the world; the cessation of large-scale gold sales by Western central banks and the rising appetite by a number of emerging country central banks to accumulate gold reserves; the price inelasticity of gold mine supply and the likelihood that mine output will stagnate for years to come; and, of course, the monetary/fiscal policy mess in the United States, Europe and Japan.
Although gold's decade-long ascent has been powered by multiple pistons, the latest sharp move up was triggered principally by rising expectations of more money supply creation by the Federal Reserve and the central banks of a number of other major economic powers.
In recent days, it has become increasingly apparent that the United States, eurozone, UK, Japan and other major economies may be heading into a period of competitive devaluations and still more aggressive monetary creation. Similarly, China and some of the other strong-currency countries are acting to slow revaluations of their own currencies in order to maintain a competitive edge in world markets.
Central bankers everywhere are responding to domestic political pressure to promote domestic employment and income growth—believing that exchange-rate undervaluation will boost exports, restrain imports and support its local economy.
This is the wrong medicine for what ails the world economy.
Rather than boost world trade and global business activity, these policies—like the "beggar thy neighbor" trade barriers erected in the midst of the Great Depression—will retard economic expansion and hurt employment everywhere.
At the same time, these policies will boost world commodity prices—and domestic inflation in countries seeking to win the currency devaluation game.
Unfortunately, what I foresee for the U.S. and other mature industrial economies is an extended multi-year stagflation punctuated with periods of actual, or near, recession much like the decade of the 1970s. In fact, we are already there with years to go before a full restoration of economic health and rising prosperity.
Mirroring the experience of the 1970s, we are also in the midst of a great bull market for gold—with gold prices set to zoom in the years ahead as commodity prices rise and inflation accelerates.
U.S. policymakers and many private sector economists tell us inflation is not—and will not—be a problem because of low capacity utilization and high unemployment—what they are calling economic "slack." Instead, we are told deflation is the problem and, in this Alice-In-Wonderland world, inflation is the solution.
Recent statements by Fed officials suggest the central bank may soon embark on a new tack of targeting an increase in consumer price inflation, possibly to an annual rate of 3% or more. With nominal short-term interest rates already near zero, they suggest a pickup in inflation will push real (inflation-adjusted) interest rates into negative territory and stimulate borrowing by households and businesses.
What they aren't saying, but just as importantly, higher inflation will raise growth in nominal personal income and nominal gross domestic product (GDP)—thereby reducing the burden of existing debt and reducing the debt-to-income and debt-to-GDP ratios back toward historical norms.
Speaking of history, slack in the 1970s did not prevent a sharp rise in commodity prices and an acceleration of U.S. consumer price inflation to double-digit rates late in the decade. Conveniently, it's forgotten that historical episodes of high inflation and hyperinflation haven't been periods of robust business activity—quite the contrary, as demonstrated by Weimar Germany in the 1920s or Zimbabwe today.
Remember, inflation is, first and foremost, a monetary phenomenon—too many dollars and too much debt relative to the available supply of goods and services. And, there is no limit to the Fed's ability to create more dollars. It is only a matter of time before the past and continuing rise in money supply, what the Fed calls quantitative easing, and the need to finance huge U.S. Federal budget deficit, result in an acceleration in U.S. consumer price inflation.
Listening to the Fed
Recent announcements by Federal Reserve Board Chairman Ben Bernanke and other Fed officials have been laying the foundation—and preparing the financial markets—for a further round of "quantitative easing," Fed speak for buying U.S. Treasury securities, the counterpart of which is the creation of more high-powered money.
In its official statement following September's meeting of the Federal Open Market Committee (FMOC), the Fed's policy-setting group, it said it is "prepared to provide additional accommodation if needed to support the economic recovery."
Many Fed-watching economists now believe the next big change in monetary policy will be announced immediately following the FOMC meeting in early November. If so, this next phase of monetary accommodation could give the gold market another significant upward jolt. But, if gold investors are overestimating just how far the Fed is willing to go this time, gold prices take a tumble.
Rather than announce another massive bond purchase with a finite end, as it did in March 2009 on launching its program to buy $1.7 trillion in Treasury and mortgage-backed securities, now the Fed will probably shift to open-ended, occasional Treasury purchases and possibly other securities with no fixed end date. Ostensibly, this will allow the Fed to limit the size and timeline of this coming round of quantitative easing (QE)—what Fed watchers have already dubbed "QE2." And wording to this effect will probably pepper their public policy statements.
But, it also will give the Fed latitude to pursue a larger and longer stimulative program of money creation, a course it will likely steer as the evidence builds of a prolonged "double-dip" recessionary economy, a scenario we have been predicting for more than a year now.
I think the Fed could easily wind up purchasing another trillion dollars or so of Treasury, mortgage, and maybe even private-sector debt in the next year—more or less the entire annual U.S. Federal budget deficit—a stimulative monetary policy that would be tremendously bullish for gold.
To paraphrase Nelson Bunker Hunt, who reportedly lost a billion dollars trying to corner the silver market in 1980, "A trillion dollars ain't what it used to be." But it's quite enough in Federal Reserve monetary creation to give gold quite a lift.
Consumer Price Index: More Than Meets the Eye
At the November FOMC meeting, the Fed may also launch QE2 and raise its "informal" inflation target from 2% to an "official" inflation target of 3% or more.
While most investors may believe the accuracy of official U.S. consumer price data—apparently the Fed does, too—I believe the Consumer Price Index (CPI) is under-reporting actual inflation by at least a percentage point and possibly much more. This makes inflation targeting a risky business because the compass by which the Fed will steer is itself flawed.
A number of factors skew the official U.S. consumer price statistics downward: First, the imputed cost of housing has been reduced by falling home prices—even though most of us are paying more for a roof over our heads. Second, since 1990, the index has been based on a variable basket of goods and services that reduces the weighting of more expensive purchases and increases the weighting of less expensive goods and services. Third, the CPI is adjusted downward to account for the qualitative improvements in the goods and services we buy—even though we might have been just as happy with last year's model.
Although many investors and economists in and out of government do believe the official data, most consumers are feeling the effect of rising prices for food and energy, which policymakers avoid by focusing on the "core" rate of inflation that excludes these categories.
Policymakers also look at the yield differential between ordinary Treasury securities and "Treasury Inflation Protected" securities, the so-called "TIP spread," as an indicator of inflation expectations in the financial markets. The TIP spread reveals that most investors remain relatively unconcerned about a serious acceleration in U.S. consumer price inflation. Or, it could be that the Fed's purchase of securities is diminishing the reliability of the TIP spread as an indicator of inflation expectations.
Choosing to see inflation as benign and talking about deflation fears gives the Fed and other Washington policymakers leeway to navigate the inflationary course they are now pursuing. Over time, more investors will migrate to the inflation camp—recognizing the true long-term inflationary consequences of the Fed's loose-money, quantitative-easing, and dollar-bashing policies. And, as they do, some will seek the safety, security and inflation protection of gold.
Few seem to remember that it was "only" an inflation rate around 4% that pushed President Nixon to impose "emergency" price and wage controls in August 1971, simultaneously slamming shut the U.S. Treasury's "gold window" and severing the last official link between the dollar and gold—thereby triggering the decade-long rise in the metal's price.
Transmitting Inflation Abroad
Quantitative easing is also the mechanism through which the Fed attempts to devalue the U.S. dollar against other currencies. In effect, the Fed purchases foreign currencies with newly created dollars. In turn, efforts by other countries to devalue their currencies or maintain relative undervaluation, as in the case of China, requires their central banks to purchase dollars with their own newly created money.
So, efforts by a number of countries to manage devaluations, or under valuations, of their currencies will boost money supply growth in the various countries playing the game—and will globalize the coming acceleration in inflation.
As investors around the world see rising commodity prices and accelerating consumer price inflation—not just in the United States but also in their own countries—many will turn to gold to protect the real value of their savings and wealth.
Monetary Policy, Competitive Devaluation, Inflation Targeting. . .and the Future Price of Gold