Fed Liquidity: Good as Gold

By Scott Silva

Editor,  The Gold Speculator

3-20-12

We all have experienced that sinking feeling when in difficult times; we seem to have run out of options. Sometimes our frustration gets the better of us as we lash out at anyone or anything however innocent. But kicking the dog is no solution to our problems.

Chairman Bernanke is acting beyond reason lately. He has realized what others have known for some time--his monetary stimulus has failed to jump start the economy. The Fed is now grabbing at straws, hoping that “increased visibility” into Fed forecasts, and “closer communication” with the public will somehow reverse the ebbing economic tide. The Fed chief seems at ends, ready to point the blaming finger at unsustainable fiscal spending and Congressional gridlock, and phantom “headwinds” as the culprits for the stalled economy.

But increased visibility into Fed forecast models is not helping. New economic data is inconsistent and contradictory. Much of it is biased by re-election campaign politics which mask actual data with much more optimistic numbers. Actual US unemployment for February, for instance, was 14.1% (U-6), not the 8.3% that the administration touts. Likewise, the Fed understates inflation, and forecasts optimistic inflation “central tendencies”.

The fact is, Fed monetary policy has been ineffective. Monetary policy cannot fix unchecked deficit spending, massive Federal debt and oppressive federal taxes and regulation. Rather than allow market forces to correct, the Fed is overwhelmed by the urge to take action. The Fed action is limited to maintaining its zero interest rate policy and buying more bonds. So Wall Street hangs on every word. When Bernanke does not mention QE3, as he did in his last public meeting, the markets plummet. When the Wall Street Journal reports the Fed is considering a new “sterilized” bond buying spree, the Dow jumps 200 points. This is no way to build the foundation for sustained economic recovery.

What we can rely on is more of the same from the Fed. As new uneven economic data emerges, the Fed will fall back to a third dollop of Quantitative Easing. Most bank economists have already trimmed GDP estimates for 1Q2012 down to 1.7% from 3.0% last quarter. Higher oil and gasoline prices are already slowing economic activity. Last week, consumer confidence fell below expectations. Friday, Chicago Fed president Charles Evans called for the Fed to take additional action now to “accelerate the pace of recovery”.

The EU is fully aboard the QE bandwagon. It will add another €1Trillion to combat the debt crisis. China is also easing. Election-year politics are likely to muddle things further. The president needs to show some improvement in the economy to be re-elected. So far his record has been dismal on that count. So his economic team will be pushing the Fed to buy more bonds. What this means for investors is more volatility and more QE is on the way.

QE, the Dollar and Gold

We have seen the effect QE has had on the value of the Dollar and the price of gold. QE weakens the Dollar and boosts gold prices. This is because adding to the money supply debases the currency which reduces its purchasing power. When the Dollar is weak, it takes more Dollars to buy an ounce of gold, so the price of gold in Dollars rises. That is why people over the centuries have stored their wealth in gold.

One of the primary stimulus measures implemented by the Federal Reserve over the last three years has been the injection of cash into the economy by giving money to the banks. The scale of the cash injection is unprecedented– officially, the Fed has pumped over $2.3 Trillion into the banks. The Fed also pumped more than $16 Trillion into banks in secret loans recently uncovered by Congressional audit. In 2009, the US economy was in a deep recession, with the potential, it was thought, to slip into the Second Great Depression. The Fed and many demand-side economists believed that adding liquidity during a period of deflationary recession would have a stimulative effect on the economy. With more credit from the Fed, banks would lend more, making more money available to consumers to spend and businesses to expand to meet the increased demand. Recession would then give way to broad economic expansion and prosperity, with low unemployment, rising wages and strong GDP growth.

The idea that increasing the money stock increases aggregate demand has been around for decades. In 1936, John Maynard Keynes first presented the idea in The General Theory of Employment, Interest and Money.  Keynes believed that government is more effective than the private sector at stabilizing the business cycle.  In his model, control is applied by central bank monetary policy and government fiscal policy. Keynesian theory served as the economic model during the later part of the Great Depression, World War II, and the post-war economic expansion. Japan implemented Keynesian policies in the 1990’s; the “Lost Decade” resulted. Since the financial crisis of 2007, the US, the UK and much of the EU have relied on Keynesian stimulus programs as the basis of their recovery efforts.

Quantitative Easing (QE) has weakened the currency in every case. We can see the effect QE on the Dollar.

We have seen the effects of Fed monetary policy on the US Dollar. The Dollar buys 17% less today than it did in 2009 when the Fed increased its balance sheet with bonds paid for by printing money.  The new “sterilized” bond-buying of QE3 will further debase the Dollar, shrinking its purchasing power for all who use the currency.

Many see similarities to the 1970’s in the today’s economic conditions. The US economy was failing during the Carter years. The 1970’s were characterized by “stagflation”, that debilitating mix of high inflation and slow growth. Double digit inflation, single digit growth and lack of leadership forced Carter out after a single term as president. 

Today oil prices are high, prices for food and other necessities are high, unemployment is high and the economy is limping along, barely growing. The misery index, coined in the 1970’s, has returned as a measure of popular dissatisfaction with the nation’s economic policies.

Chairman Bernanke’s Fed policies are similar to Fed policies in the 1970’s. In both periods, the Fed responded to recession by expanding the money supply, although the scale of monetary expansion in the recent case is unprecedented. Under Fed Chairman Burns, monthly money growth, which had averaged 3.2 percent in the first quarter of 1971, jumped to 11 percent in the same period of 1972. The money supply grew 25 percent faster in 1972 compared to 1971. Money supply growth under Chairman Bernanke has been nothing short of remarkable.

Debasement of the Dollar has made many eager to shift out of Dollar denominated assets into hard, commoditized assets precisely because dollars are losing value. We have seen this trend in history. Gold prices tripled in 1980-1981; gold has double in price since 2009. Prior Fed QE policy has boosted the price of gold, and QE3 at $1Trillion will likely push gold above $2000/oz.

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