All That Glitters

Gold is all the rage, having broken the key $1000 price level this past week. The break out appears powerful and launches from a well formed price pattern that seems well suited to support a 20 – 30% run.

This move comes as the US Dollar mounts a break out of its own, this one to the downside. The buck seems set to test last year’s multi-decade lows.

These are well known inflation signals. But with inflation readings in check, US Treasury rates going down and the Commodity Research Bureau Index having collapsed from all time highs last year and not mounting much of a bounce there seem to be conflicting signals in the air. After all if inflation is incipient we should expect to see US Treasury rates going up and the price of commodities other than gold (and silver) accelerating.

We can’t be blamed for asking if the move in gold is a bull trap.

The bursting of liquidity bubbles tends to be a deflationary event. We saw this with The Great Depression in the United States and in 1990’s Japan where prices collapsed and the economies along with them.

The key lesson of these events is that to fight the bursting of a liquidity bubble one must flood the system with liquidity. That doesn’t mean passing pork laden stimulus bills designed to stimulate nothing but your supporters’ interests. It refers to making sufficient liquidity available in the system to insure that it can continue to function and allow losses to be taken.

During the Depression liquidity was removed. The price of money was increased and the system was allowed to collapse upon itself under Hoover Treasury Secretary Andrew Mellon’s “liquidation” policies.

In 2008 the Federal Reserve Bank did just the opposite. They initiated numerous programs to insure that the system wouldn’t collapse, accepting moribund collateral from myriad financial institutions in exchange for cash, enabling the system to continue operating. And they have monetized US Treasury debt to insure the price of funds stays as low as possible in an effort to nurse the financial system back to health by providing financial companies with the cheapest possible source of funds, thus insuring profitable margins in lending operations.

In so doing they have massively increased the money supply. The late Nobel economist Milton Friedman (a hero of this blog) taught us that “inflation is always and everywhere a monetary phenomenon.” The break out in gold and decline of the dollar are the market’s reaction to increased dollars in the system, which the market fears will lead to sharply accelerating inflation.

But this doesn’t have to happen.

What’s missing from the equation is demand. Simply stated heretofore there hasn’t been very much of it for all the money that is sitting in the system. The rate at which money “turns over” is called velocity and without sufficient velocity inflation will not make an appearance.

But we’ve had numerous signals over the last month or longer that recovery is taking shape and growth is returning. It is those signals to which gold and the dollar are likely responding. As growth gears up so will the velocity of money and with it inflation could well rear its ugly head.

It is therefore incumbent upon the Fed to begin to remove this heavily spiked punch bowl. They have already announced they will begin to phase out some of the liquidity programs they introduced last year. Further announcements are likely to follow. If the Fed can remove sufficient liquidity from the system inflation does not have to rear up. That could well be the reason interest rates are staying put and commodities other than gold and silver are not taking off. The market is conflicted and there is at least some confidence that The Fed is up to the task.

Frankly we have our doubts. The Fed is a non-political institution and technically free from pressure from lawmakers and the administration. But with Democrats firmly in control of the government their key concern is likely to be unemployment. Not that Republicans don’t care about jobs, but Democrats have a key constituent in the union movement that is likely to be quite vocal about an unaddressed unemployment rate that is moving rapidly towards 10%. Both they and their patrons believe government can dictate employment and The Fed is likely to feel tremendous pressure to leave liquidity in place until unemployment begins to move lower.

That would be a tragic error. Employment is a lagging indicator. It is one of the last things to improve when growth returns to the economy. To wait until employment is recovering is to wait far too long.

Of course removing liquidity won’t necessarily be a painless task. It could well dampen the recovery. The Fed has a delicate balancing act on its hands. It will no doubt be pilloried from all sides in the months ahead as one interest or another fears the consequences of The Fed’s actions (or lack thereof).

We hope Mr. Bernanke has a rabbit deep in his hat. In the meantime we are long gold, per our companion blog, but secretly hope it’s not a successful trade.