Gold keeps doing what it does best as Fed promises three more years of easy money

On Wednesday, the central planners at the Federal Reserve announced that they will continue distorting the markets by manipulating interest rates to near-zero at least through 2014.

Gold took off like a rocket, rising more than $50 intraday.

Chart: Bloomberg

Stocks, the object of Ben Bernanke's obsession, didn't keep up, rising only one percent and then fading the next day.

Chart: Bloomberg

There is a stunning amount of ignorance and misinformation about gold among the public, the financial press, and economists. Remember when banker Richard Wiggins trashed gold at $1200 in Barron's? And witness the ignorance in the comments here, including from economist Barkley Rosser, about gold being in a bubble in 2010 at $1200. Personal finance guru Dave Ramsey, who is otherwise generally outstanding, has been telling people to dump gold for years, including here in October 2009 with gold at $1000.

Many people think of gold as an inflation hedge, and can't understand why gold goes up while the CPI is flat.     The truth is that gold is a hedge against currency debasement, which is a very different thing than consumer inflation.  The CPI remains contained for two reasons: 1) depressed demand and 2) biased index construction.

After a multi-decade borrowing and spending orgy, consumers are tapped out and are trying to repair their balance sheets. So even as the Fed prints money, consumers don't spend enough to create significant inflation. And while there is inflation in the things consumers need (food, gas, utilities), it is masked by the price drops in discretionary items like flat screens and cheap Chinese crap. Additionally, the BLS makes "quality" (cars now have airbags and ABS brakes, so we're going to pretend prices didn't increase as much) and "substitution" (steak is so expensive that nobody eats it anymore, so we'll take it out of the index and replace it with hamburger) adjustments that systematically reduce reported CPI inflation.

So if CPI inflation doesn't explain the increase in gold prices, what does?

Two things: the national debt and the Federal Reserve balance sheet.     Here's a history of gold along with U.S. debt as measured by the IMF's Gross Government Debt.  Pretty compelling, huh?

Chart: Bloomberg

We are now in our fourth year of trillion-dollar deficits, and the debt/GDP ratio just passed 100%.  The dollar is falling against gold because that debt can't possibly be paid off, or even the interest serviced, in today's dollars.  Interest and maturing debt are paid by issuing more debt!  And the cowardly Congressional Republicans have folded on the debt ceiling and the budget continuing resolution and agreed to keep spending even more than we did under Reid/Pelosi/Obama.  Unless you think Congress is going to reverse course and start running budget surpluses, that white line is headed higher.  I'll leave it to you to judge what that implies for the gold line.

As for the Federal Reserve's effect on gold, here's a chart of the Federal Reserve balance sheet (essentially the amount of money it has printed out of thin air) along with gold prices.

Chart: Bloomberg

The Fed's Wednesday declaration of free money for three years is not an explicit promise of further balance sheet expansion, but it's an indication that that is the direction that the Fed is leaning.  And with the Treasury still running trillion-dollar deficits, somebody's got to buy all that new debt.  The Fed is likely to continue being the Treasury's handmaiden, especially if foreign buyers continue backing away.  Remember the old days where everyone was talking about the Fed "exit strategy?"  You haven't heard that phrase lately, have you?  Funny how that is.

I've said it before and I'll say it again: the dollar is a convenient medium of exchange but it is absolutely NOT a store of value.  Any financial adviser who doesn't recommend gold as an essential part of a balanced portfolio is recklessly irresponsible.


Independent Accountant said...

You got it! As I said before, "No exit. ... Got gold? Get more"!


Anonymous said...

And you, W.C., are equally irresponsible in trying to push the average investor into a commodity which is fraught with risk, a commodity that shows a quite poor correlation to the dollar as a 'hedge' (-0.27 over the long run), a commodity whose cost of production is $600 but is selling for thrice as much , and a commodity which is saddled with the largest known overhang of any that mankind produces (170000 tons). Gold is many things to many people but an inflation and dollar hedge it is most certainly not. Even if the Fed did create conditions for it to bubble up to where it now is. This too, shall passs.

W.C. Varones said...

What we've got here is failure to communicate. Some men you just can't reach.

SarahB said...

Well explained! I'm constantly horrified at the otherwise intelligent people who still don't understand currency or inflation...and the intellectuals who pretend the rules can be bent for agendas.

Gold Dealer said...

It sure looks like a bubble on this graph! So abrupt... I guess it counts how you look at it... if you compress it a bit, the "bubble" reveals itself!
It is indeed a bubble, we just don't know when it'll pop!

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