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July 29, 2004

Money Matters & Gold # 3
by Ned W. Schmidt

In a recent issue of THE VALUE VIEW GOLD REPORT we considered a graph of various measures of the rate of change of the U.S. consumer price index. As most others agree, a change in inflationary conditions seems evident. Even the Federal Reserve may be adjusting its thinking somewhat. That conclusion acknowledges all the criticisms and discussions of the problems with measurement.

The real issue though may be the question of whether or not the recent tendency toward higher prices is being monetized. When prices rise, such as the recent experience with oil, the central bank has two fundamental choices. First, the central bank could let market forces dictate the response. In this case the rate of interest would rise to reflect the higher prices. In the short-term, this action might result in a lower level of economic activity.

That lower level of economic activity should lead to a correction in the sources of rising prices. Demand for goods would fall. The higher prices for goods, oil included, would ultimately fall back down. In this case the natural workings of the markets adjust, and the higher prices are not built into the system. Market can naturally adjust to such forces if allowed to do so.

However, the Federal Reserve does not like to let market forces work naturally. Having made the assumption that the collective wisdom at the Federal Reserve is greater than that of the market, it will not allow markets to react naturally. The Federal Reserve's wisdom is substituted for market wisdom. This mistake of arrogance is commonly made by central banks.

The Federal Reserve's wisdom sets the level of interest rates. Rather than let market interest rates react naturally to supply and demand pressures, it fixes those rates. That action requires the Federal Reserve to supply reserves whenever the market has a tendency to raise rates. This move keeps rates fixed at the prescribed level, but monetizes any price increases. That means it provides enough money to cause the markets to accommodate and accept the higher prices.

Sufficient "money" is provided the system to keep interest rates fixed. Since more money is now in the system, the inflationary tendency of the economy is higher. Such is the simplified view of how the Federal Reserve actions monetized recent price increases, such as those of oil. Little criticism can be leveled at the central bank of China for its policy decisions, when similar such actions are being taken by the U.S. central bank.

Before going further with this look at monetization of higher prices let us take a quick look at the results of Federal Reserve policy. In our first chart is the year-to-year change in U.S. M-1, the narrowest measure of money. Some obvious observations stand out, and are worthy of mention.

First, stability is apparently not an important consideration in the development of Federal Reserve policy. Little evidence of a stable policy, however defined, can be found in that graph. Monetary instability leads to economic instability. Such is the reason the U.S. economy has experienced a stock market bubble, a housing & mortgage bubble and the likelihood of currency depreciation of a significant magnitude.

Second, the U.S. economy has been supplied with monetary "juice" at an accelerating rate. Monetary policy has been set without consideration of possible adverse consequences, or more dangerously the cumulative negative impact on the U.S. economic system. The impact of higher and higher rates of monetary expansion on stability, both economic and price, has not been a consideration.

Generally accepted is that the money supply should not grow faster than the growth rate of the economy's ability to produce goods. Let us accept that. If the money supply grows faster than the growth rate of the economy's ability to produce goods that action is deemed to be inflationary. The reverse is generally also accepted.

What we have done in the second graph is plot this tendency of monetary policy to be either inflationary or deflationary. To do this each month the year-to-year change in the narrow money supply, M-1, is calculated. From that value 3% is subtracted. Three percent is probably a reasonable estimate of the growth of the long-term potential of the economy. If the year-to-year change exceeds 3%, then monetary policy is conducive to higher prices developing.

A ten-month moving average is then calculated, and that is what appears in the graph. If that value is positive, monetary policy is conducive to higher prices. If the plot is negative, the impact of monetary pressure is negative on prices.

Three distinct periods of monetary pressure are evident in the graph. In the early 1990s the impact of Japanese banking fading from the scene had not yet appeared. Then a long period of monetary conditions depressing prices developed. This is shown by the measure being in negative territory. Previously we have written how this era was largely due to the withdrawing inward of the Japanese banking system.

More recently we see that the monetary influence is positive. This condition has manifested itself in exploding housing prices and much higher rates of increases of other prices. An era of monetary policy encouraging higher prices has been evident for some time. That effort to boost prices has now been seen in many sectors, and has encouraged the depreciation of the U.S. dollar.

Naturally our curiosity took hold. To that plot we added the monthly average price of Gold, the solid line. That appears in the third graph. Here we now have an interesting picture. Also, included are two triangles. The triangle pointing down is when this monetary measure last turned negative. A second triangle, pointing up, is when the measure turned positive.

In short, when monetary policy is exerting a depressing force on prices Gold does not do well. When monetary policy is a positive force on prices, Gold does well. Those results are as we would expect. Most important though is that the measure continues positive suggesting that Gold should continue to do well. Since this measure is more like an oscillator than an index, the level of the measure and the price of Gold are not particularly comparable.

Now let us tie this graph in with whatever a "measured" response might be. The Federal Reserve is saying, as so many others have commented, that taking away the punch bowl in a hurry is not likely to happen. Waiting is more likely to be the approach to raising rates. In the mean time, price increases are being monetized and the cumulative danger to the dollar continues to compound.

Potential investors on Gold need to keep attention on the longer term impact of Federal Reserve policy. The Fed has never got "religion" till salvation was a necessity. That approach is not likely to change. Central banks just do not have a tendency to do the "right thing." Why else would Gold have survived while fiat currencies have faded?

In the day of money moving on the click of a mouse, volatility in the dollar and markets is going to cause Gold to also be volatile. More important is what will happen tomorrow to the dollar, not what happens today based on a measure of last month's consumers' confidence. Investors should use these opportunities to add to their Gold positions.

As our last graph shows, these reactions in the price of Gold create opportunities for investors. One of the fundamental laws of finance is as the price declines, the future return on Gold simply rises. Let the stock junkies compound their losses on consumer confidence estimates while you increase your future returns. By the way the Silver chart has also flashed a buy signal. So enjoy the ride in Gold($1,200+) and Silver($21+), but do so by increasing your profits through wise purchasing on price corrections.

Ned W. Schmidt,CFA,CEBS
THE VALUE VIEW GOLD REPORT

Ned W. Schmidt,CFA,CEBS is publisher of THE VALUE VIEW GOLD REPORT and author of "$1,265 GOLD", published in 2003. A weekly message, TRADING THOUGHTS, is also available to electronic subscribers. You can obtain a copy of the last issue of THE VALUE VIEW GOLD REPORT at http://home.att.net/~nwschmidt/Send_Last_Report.html Ned welcomes your comments and questions, and tries to answer most all. His mission in life is to rescue investors from the abyss of financial assets and the coming collapse of the U.S. dollar. He can be contacted at nwschmidt@earthlink.net.

Copyright © 2003-2008 Ned W. Schmidt

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