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Price Inflation on the Horizon

November 4, 2009 by  

Price Inflation on the Horizon

As we noted last time in Gold Defying Expectations…and Gravity, we’ve seen gold and U.S. stocks marching in lockstep, in perfect opposition to the moves of the dollar.

So why does a weaker dollar translate to strength in gold and equities? Because, on balance, a weaker dollar is a lubricant for a U.S. economy saddled with debt and low growth. It eats away at debts; it helps boost trade, and generally makes for a more ebullient economic environment.

But I believe that one of the primary reasons behind this relationship has escaped most analysts. Namely, the fact that economic growth will help burst open the dam holding back enormous U.S. bank reserves.

Investors are watching closely for any signs of an economic recovery because such a recovery could unlock the U.S. credit market… and unleash a flood of liquidity that—so far—remains safely dammed.

U.S. bank excess reserves have skyrocketed to truly unprecedented levels. (Essentially, excess bank reserves are reserves on deposit with the Fed over and above what the bank needs to meet its reserve requirements.)

Now, these reserves don’t impact the money supply—as long as they aren’t loaned out by the banks and thereby put into commerce. And these funds by and large have not yet been put into commerce, and therefore have had no effect on the supply of money or the prices of goods and services.

That may not last for long, however, as economic growth in the U.S. would, eventually, lead banks that are now risk-averse to begin lending. This, in turn, could quickly burst the dam holding back the enormous excess reserves of the U.S. banking system.

Some argue that the Fed’s newly gained power to pay interest on banks’ reserves will forestall any unwanted increase in lending. In practice, however, this will have little effect, unless the Fed is willing to pay interest at rates far above the Fed funds target rate.

As Frank Shostak, chief economist of M.F. Global, notes, “We… suggest that paying interest on bank reserves is not going to stop banks from expanding credit… After all, there are always opportunities to lend money at much higher interest rates than the federal-funds rate.

“We can thus conclude that the massive increase in banks’ excess reserves is a potential threat for an explosive credit creation some time in the future. Contrary to popular thinking, we suggest that the new setup, which gives the Fed total freedom to pump money, can only destabilize the financial system and the economy.”

Of course, this isn’t the last word. Only time will tell how we exit the precarious monetary situation that the crisis, and the Fed’s response to it, have created.

But those who argue that the Fed will be able to mop up the massive liquidity they’ve poured onto the economy ignore the fact that this institution, and governments in general, have never been able to escape from a monetary expansion without significant inflationary after-effects.

And because the Fed is now treading new ground in many ways, they cannot rely on past experiences to clearly guide them.

If we pull back from the economic intricacies and simply look at the big picture, does it seem remotely feasible that the U.S. and the world can employ such monetary and debt expansion without considerable inflationary consequences?

While I have many reasons to be doubtful that we’ll see 70s-era price inflation as measured by the consumer price index (CPI), I am absolutely confident that we will see price inflation in commodities and other assets.

And that will be good news for investors in gold and resource stocks.

Fed Admits Hiding Gold Swap Arrangements
Our friends at the Gold Anti-Trust Action Committee (GATA) have scored another huge coup. In response to a freedom-of-information (FOI) request, the Fed has essentially admitted that it has gold swap agreements with foreign banks that it doesn’t want publically acknowledged.

GATA had requested from the Fed any information or correspondence on gold swaps, which are transactions in which monetary gold is temporarily exchanged between central banks or between central banks and bullion banks.

But GATA’s request was denied, and the organization’s appeal was answered by a Sept. 17 letter from Federal Reserve Board member Kevin M. Warsh, who was formerly a member of the President’s Working Group on Financial Markets.

Warsh wrote that, “In connection with your appeal, I have confirmed that the information withheld under Exemption 4 consists of confidential commercial or financial information relating to the operations of the Federal Reserve Banks that was obtained within the meaning of Exemption 4. This includes information relating to swap arrangements with foreign banks on behalf of the Federal Reserve System and is not the type of information that is customarily disclosed to the public. This information was properly withheld from you.”

As GATA secretary and cofounder Chris Powell notes, “The disclosure contradicts denials provided by the Fed to GATA in 2001 and suggests that the Fed is indeed very much involved in the surreptitious international central bank manipulation of the gold price particularly and the currency markets generally.”

GATA has the right to further appeal through the legal system, and plans to do exactly that. A federal lawsuit will be quite expensive, but well worth it for gold investors who need market transparency to unlock gold’s true value in today’s uncertain world.

As you may know, I’ve never been a big believer in day-to-day manipulation of the gold market by the “powers that be.” But I do believe that governments have and are acting over the long term to keep gold in chains. They’ve done it before, both covertly and openly. And they currently manipulate every other investment market. So why wouldn’t they also do it in gold, the very measuring gauge of their performance?

So I urge all serious gold and resource stock investors to help GATA out. It’s not just their cause—it’s a cause for all of us. GATA is recognized by the U.S. Internal Revenue Service (IRS) as a nonprofit educational and civil rights organization and contributions to it are federally tax-exempt in the United States.

Just as important, you can help by bringing this issue to the attention of news organizations and other investors. With the U.S. dollar at a crucial turning point, and with the International Monetary Fund (IMF) and other official organs needing to keep the gold price suppressed, it has never been more important to make the gold market open, transparent and honest again. To learn more about GATA, this issue and how to donate, visit www.gata.org.

—Brien Lundin

Brien Lundin

is the editor and publisher of Gold Newsletter, a publication that has ranked among the world's leading precious metals and resource stock advisories since 1971. To learn more about Gold Newsletter, visit www.goldnewsletter.com. Mr. Lundin is also the host of the famed New Orleans Investment Conference, the world's oldest and most respected gold investment event. To learn more, visit www.neworleansconference.com.

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