Delusion, Divergence & the Dollar

By: Ned W. Schmidt | Thu, Feb 5, 2004
Print Email

HEADLINE from 2013:
FEDERAL RESERVE ADMITS POLICY ERROR

Washington: In a historic press conference today the Board of Governors of the Federal Reserve System released a statement admitting to a policy error. Observers noted that what made the event newsworthy was not that the Fed made an error. Rather, what was special about the announcement was that the admission that they made a policy error. An analyst for a world renowned think tank commented, "Once in a hundred years is a good start."

Perhaps the most incredible speech of this century to date is that of the Chairman of the Federal Reserve System to the American Economic Association on the 3rd day of January. This group may be the one most appropriate for a speech attempting to validate inept policy formulation. In that speech Greenspan said,

" It is far from obvious that bubbles, even if identified early, can be preempted at lower cost than a substantial economic contraction and possible financial destabilization - the very outcomes we would be seeking to avoid.... The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble while preserving economic stability is almost surely an illusion." (www.federalreserve.gov/boarddocs/speeches/2004)

The above comments say essentially that the economic costs of preventing the stock market bubble would have been greater than the costs experienced by the popping of the bubble. Reaching such a conclusion is difficult, and a sign of dubious thinking. We are being told that preventing the bubble would have cost investors more than the trillions of dollars that were lost. In short, the Chairman concludes that investors are better off with the popping of the stock market bubble and the trillions of dollars of losses they have experienced.

Does the Chairman really believe that preventing the bubble would have cost the U.S. economy more that the 2+ million lost in the popping of the bubble? According to this view, investors should feel elated that the Federal Reserve let the bubble inflate and then pop cause they could have lost more than the trillions of dollars they lost. Does anyone really believe that the pain of avoiding an injury is greater than an injury?

Delusions persist at the Federal Reserve. The misguided thinking outlined above is not an isolated example from that institution. Regardless of the failure of its policies, some rationalization continues to spew forth. And the crashing dollar will soon show that the belief that the Federal Reserve controls inflation is another form of deluded reasoning.

Several important reasons exist for again turning to this speech. A lot is said about the Fed's attitude toward economic bubbles. A mountain of meaning is hidden in the Fed's views. Implications exist for both investors and captains of industry. Consider the possibilities that follow:

The Federal Reserve will continue to deny the existence of a Housing & Mortgage Financing Bubble. It would rather clean up after the bust than stop it now.

The Federal Reserve will allow the development of a bubble in non-dollar currencies. It would rather clean up after the dollar is devalued rather than step in now.

The Federal Reserve will take no action to prevent the inflating of a Dollar Gold Bubble. Hopefully, we will have escaped with our profits before the Fed has to clean up again.

Economic and financial bubbles have been the primary manifestation of U.S. monetary policy. Our goal is to identify these events, and discern the way in which to take advantage of them. Each offers both difficulties and in some way profitable opportunity. From the above we can form some investment/business implications:

The Housing Bubble will be allowed to burst.

The Mortgage Financing Bubble will be allowed to burst.

The U.S. dollar's devaluation is in infancy. Reality is likely to be closer to scare stories than the rosy scenarios. Is the Euro worth $2.50? 3.00? $4.00? Is the dollar worth 80 yen? 70 yen? 50 yen?

Interest rates are about to embark on a rising trend that will endure for many years, and carry long-term rates back into double digits. Equity prices and financial institutions will not prosper during this period.

This author may be too pessimistic with a target of $1,272+ for Gold and $21+ for Silver.

Precious metals, commodities and export oriented businesses will prosper highly in the coming years.

American agriculture may experience an era of rising exports.

One of the implications of the Federal Reserve's lack of concern for bubbles is that we must look for divergences between reality and theirs words of happiness. Where are the trends that do not support the positive views of economic and/or financial conditions? Does this mean we are simply looking for negatives? No, for if the Federal Reserve is not likely to take precautionary action that means investors and businesses must do so. The costs of riding the Fed's waves up and then down can be fairly high.

Consider the example in the graph. Portrayed is the year-to-year change in a measure of U.S. money supply, M-2. Several interesting trends and developments are shown. First, we can observe the long period of aggressive monetary easing from the early 1990s till the latter part of that decade. The continuing quest for an ever higher rate of monetary expansion led ultimately to the stock market bubble.

When that rate of monetary ease got above the 6% level, animal emotions were ignited in the equity markets. That speculative fervor continued till the rate of increase in M-2 slowed for a period of time and then declined down through the 6% level. A triangle marks the timing of the end of the stock market bubble.

The Federal Reserve was not then done. It had to save the U.S. economy from the millennium, the introduction of the Euro, 9/11 and so on. Further easing pushed the rate of monetary expansion ever higher. Ultimately the Federal Reserve was able to create a Mortgage Financing Bubble and a Housing Bubble. Animal spirits were rejuvenated in the equity markets, though that seems about over now.

Forecasts of grand growth for the U.S. economy are now common. Recovery and expansion are at hand, so the gurus on CNBC tells us daily. But, what of the action in M-2? The rate of expansion in M-2 is collapsing. A serious question arises. Can the U.S. economy be on a growth/expansion track with the rate of change in M-2 collapsing?

The two would seem to not go together. One is wrong. Either the economy will slump or M-2's rate of growth is not really slowing dramatically. Is this an example of the divergence between forecasts and economic reality? An answer in the affirmative is most suitable.

An additional possibility needs to be considered. Is the U.S. dollar losing fans? Are people around the world less likely to keep their wealth in dollar denominated deposits? Is M-2's action signaling the end of the U.S. dollar's near 90 year run? Quite possibly. That the dollar is now a "sell" in the minds of investors around the world is a real possibility. In that case, the concerns over devaluation, import prices and interest rates have considerable merit. Gold and Silver are appropriate portfolio alternatives for investors.

The Federal Reserve is certainly not prepared to accept responsibility for its policy errors. That institution continues to operate under the delusion that fixing interest rates and economic/financial bubbles are the wisest way to act. Apparently the global currency markets and markets for Gold and Silver disagree with this view. Globally, the view of investors is diverging in a serious manner from that of the Federal Reserve.

Gold, and Silver, continue to be appropriate additions to an investor portfolio. Investors should have a larger percentage of their portfolios in precious metals than they have in U.S. equities. The wisdom of investing in Gold and Silver is no longer a matter for serious discussion.

When to buy Gold and Silver are the only questions that remain. Enthusiasm for the metals recently reached too high a level. Now that a corrective process has begun, investors can begin returning to these markets. Our indicators are now suggesting that both Gold and Silver are moving in an attractive price range. Buy signals seem more likely now, as shown in our weekly TRADING THOUGHTS. Remember, buying into the metals during periods of investor disappointment is a better idea than buying when everyone seems to want them.


 

Author: Ned W. Schmidt

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 The Value View Gold Report. 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 ned@valueviewgoldreport.com

Copyright © 2003-2016 Ned W. Schmidt

All Images, XHTML Renderings, and Source Code Copyright © Safehaven.com