Wednesday, April 22, 2009

Fed's quantitative easing, inflation and gold

Business Times - 22 Apr 2009

With West likely to debase currencies to ease debt burden in years ahead, gold and silver are safer bets.

ON March 18, the Fed used its last weapon - quantitative easing (QE), when it announced its plan to buy US$300 billion in long- term Treasuries and US$750 billion of mortgage-backed securities. On the back of this news the equity and bond markets surged, the dollar sold off but commodities rallied. Why is it a big deal? Although the Fed regularly buys and sells short-term Treasury bills to set the overnight federal funds rate, it generally does not intervene in long-term Treasuries, allowing the market to set long-term rates.

The Fed has not bought long-term Treasuries since 1952, mainly because 'it's as inflationary as hell', says Howard Simons, a strategist with Bianco Research. Gold, often seen as a hedge against inflation, surged on the news, from US$916 per ounce on March 17 to US$958 on March 19.

The Treasury is not allowed to print money because governments can tend to go a little crazy and print too much, resulting in hyperinflation and often, economic collapse. John Taylor, a Stanford University economics professor says the Fed's move 'raises huge questions about inflation and the independence of the Fed. This is unprecedented'.

I am of the view that inflation will not be a problem as long as the United States remains in a recession. The real problem would start once the economy starts to revive. That's when the banking system will start to expand the money supply. History shows, it's very, very hard for the central bank to raise interest rates rapidly enough to offset the increase in credit. That's when we are going to get the inflation.

In my opinion, QE gimmick is not going to work any better than any of the previous efforts. The question begs the answer is - how are these bailout plans going to stimulate aggregate demand of the US consumers?

As I see it, government stimulus plans are not reaching the consumer and therefore, this is not going to stimulate demand. Fed chairman Ben Bernanke himself admits that we are in uncharted waters, with no map or compass, just simply a hope that more dollars are the answer. What it is doing is saving the greedy bankers that made the bad loans. Printing money out of thin air (quantitative easing) will not fix the problem. Buying up your own debt is no more useful than swapping one credit card for another. It is the last act of desperation when there is nothing else left to do.

It is worth noting, that the Federal Reserve has already dropped the Fed funds rate to a historically low range of 0-0.25 per cent and now it is desperately trying to use other unconventional methods (quantitative easing) to stimulate the economy. This latest development of the Federal Reserve monetising debt is inflationary and confirmation that the Federal Reserve wants to debase the US dollar. It is my firm belief that over the years ahead, the US and all other debt-laden nations in the West will engage in massive money-creation in order to debase their currencies and dilute the purchasing power of paper money. Remember, monetary inflation is a debtor's best friend as it makes the debt easier to service and repay. On the other hand, monetary inflation goes against the interests of savers and creditors. Given the fact that most of the 'developed' nations are up to their eyeballs in debt, you don't have to be a genius to figure out that monetary inflation is our future. So, I don't expect deflation to take hold; rather, I anticipate accelerating inflation which has always led to rising asset and consumer prices.

If monetary inflation is our future, then we should examine which currencies and assets will maintain their purchasing power. If history is any guide, nations which engage in monetary inflation always diminish the purchasing power of their currency. So, in the years ahead, we can expect currencies in the West to depreciate in terms of purchasing power but the trouble is that none of the fundamentally sound nations want a strong currency either! As the world engages in competitive currency devaluations, I expect all the currencies in the world to lose significant purchasing power against hard assets.

Therefore, in the years ahead, precious metals and other commodities with intrinsic value should appreciate considerably. With the world in turmoil and the global financial system on the brink, there has been one relatively steady asset in the storm: gold. The gold price ended up 5.5 per cent for 2008 as stock markets plunged around the world and is currently up over 6 per cent in 2009.

The S&P 500 finished down 38.5 per cent last year and is down over 15 per cent in 2009. The US dollar has also been a safe haven asset recently, but the longer-term fundamentals of the dollar are no match for gold.

Beyond gold's value as a safe haven, the basic supply and demand fundamentals are strong as well. As gold has consistently risen in price since 2001, global gold production has actually fallen. Annual gold production is now 4 per cent less than in 2001, when the price was under US$300 per ounce. Global gold reserves in the ground are also shrinking despite concerted efforts and hundreds of millions of dollars in exploration expenditures. Finding gold is not an easy chore. It is by nature a very scarce mineral, and explorers have been scouring the earth for it for thousands of years. In addition, the rising costs of labour, equipment and energy have made mining a more difficult enterprise to get off the ground.

Contrast those hurdles to the ease with which central banks can create vast mountains of paper money at the blink of a mouse click. Is it any wonder that gold has lasted as a store of wealth for thousands of years? On the other hand, currencies rise, fall and disappear with regularity throughout history. Scarcity and intrinsic value will continue to drive gold prices higher over time relative to paper currencies. As the dollar and other currencies race to debase themselves during this financial crisis, the only remaining yardsticks of value remain gold and silver.

Since August 1971 when the US took the dollar off the gold standard, that spending discipline has disappeared as the Fed has printed money at the government's whim. Over the last 38 years US levels of debt have mushroomed, while the US$ purchasing power has declined.

It's clear that prolonged periods of excessive money creation lead to excessive speculation, debt and finally economic turmoil. It has occurred throughout the ages and is occurring today. Without the disciplining system of a gold standard, it falls on central banks to control money supply. History has shown central banks as independent in name only. They are de facto pawns of government and create whatever amount of currency that government demands.

The simplest and easiest way to buy gold is to purchase gold ETF (ticker - GLD); investors wishing to have exposure to gold mining stocks can buy ETF (ticker - GDX). Gold is the primary beneficiary of investors' fear and uncertainty, while silver often performs like an industrial metal and therefore more volatile than gold. Investors willing to buy silver can purchase silver ETF (ticker - SLV).

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