Alastair McLeod
Gabriel Mueller
The hyperbolic rate of increase, if the established trend is maintained, is now running at over $300bn monthly, while the Federal Reserve is officially expanding money at only $85bn.
The first thing to note is that the Fed issues money because it deems it necessary. The hyperbolic trend increase in the quantity of money is a reflection of this necessity, implying that if the Fed’s money issuance is at a slower rate than required, then strains will appear in the financial system. There are a number of reasons behind this monetary acceleration, not least the need to perpetuate bubbles in securities markets, but there are three major underlying problems.
Government spending
Federal government spending is accelerating, due to rapidly escalating welfare commitments, not all of which are reflected in the budget. Demographics, particularly the retirement of baby-boomers, government-sponsored healthcare, and unemployment benefits are increasing all the time; yet the tax base is contracting because of poor economic performance and tax avoidance. Furthermore, state and municipal finances are dire.
Economy
The US economy is overloaded with debt to the point that it no longer reacts positively to monetary stimulus, and successive government interventions have led misallocation of economic resources to accumulate towards crisis levels. The private sector is now teetering on the edge of an abyss overloaded by both debt and government intervention.
Commercial banks
The banks are cautious about lending to indebted borrowers, and they have failed to adequately devalue collateral against existing loans. The result is that with no bank credit being made available to support renewed buying of assets, asset valuations are constantly on the verge of collapse. Put another way, banks have backed off from creating ever-increasing levels of debt to perpetuate the pre-crisis asset bubble.
One should not take comfort in attempts to improve asset ratios. According to the Federal Deposit Insurance Corporation, the ratio of total assets to risk-adjusted Tier 1 level capital is currently 11.25; but this does not adequately reflect off-balance sheet activities and non-banking business such as derivatives. The inclusion of derivatives on US bank balance sheets as a net as opposed to gross exposure, seriously misstates actual risk.
Banks therefore face two different problems. An on-paper write-down of collateral assets of less than 9% wipes out the entire banking system, with a far lower threshold for many banks. Changes in GAAP accounting rules over asset valuations in the wake of the Lehman crisis have allowed them to hide losses, a situation that is still unresolved and suggests the banking system is already close to the edge. Furthermore, any failure in the derivative counterparty-chain threatens to trigger a collapse of the larger banks where derivative exposure is concentrated.
Conclusion
We are in the eye of a financial storm, for which the only solution – other than mass default – is an accelerating supply of money. Deteriorating financial conditions in either government, banks, private sector or securities markets are almost certain to trigger a run on the others. And that is why a far larger figure than QE3’s $85bn per month may be required to keep the system afloat.
According to the Fed’s most-recent FOMC announcement, the Fed is looking to hold the federal funds rate near 0% for “at least through mid-2015,” which means that Operation Twist – the Fed’s programme for selling its short-term government debt in order to buy more long-term government debt – is being extended for an additional year. On top of this, we have the organisation’s new commitment to buying $40bn a month of mortgage-backed securities until such a time it deems this money printing unnecessary.
See the chart below.
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The Federal Funds Rate is defined as “the interest rate at which depository institutions lend balances to each other overnight.” In other words, when one national bank is in need of more reserves (i.e., money) in order to maintain its reserve requirements, that bank can look to borrow money from another national bank that has more (or “excess”) reserves than is required. That bank then borrows from the other bank at the federal funds rate. (Note: the Discount Rate is the rate at which a national bank/institution borrows directly from the Federal Reserve.)
The rationale and hope behind manipulating the Federal Funds Rate from the Federal Reserve’s perspective is this: a lower rate will encourage banks to borrow funds from one another, which will then allow those borrowed funds to be lent out into the economy, which should then spur consumption and spending – boosting economic growth and the economy in general.
No such thing will occur, however, but the Federal Reserve can try as it may. What will occur is a strong price rise in gold, at least until 2015, and most likely beyond that as well.
If you look back at the chart above, you can see that the Federal Funds Rate jumped from approximately 5% in 1975 to over 18% in 1981. The reason this occurred was because, after being appointed in 1979, former Federal Reserve Chairman Paul Volcker pushed the rate to 20% by instructing the Federal Reserve Bank of New York to reduce its bank reserves, which in turn forced national banks to borrow less and interest rates to rise. In doing so, Chairman Volcker “saved” the dollar and annual inflation went from 12% in 1979 to 3% by 1983.
Intentionally or not, Chairman Volcker’s move also broke the back of the gold bull market and gold fell from a high of $850/oz in 1980 to almost $300/oz in 1982.
That is the power of the Federal Funds Rate: it has the ability to save the dollar and to kill gold. Simply put, it can be the gold investors best friend or worst enemy. From the gold investor’s perspective today, it is a toothless enemy and it need not be feared for a very long time to come. Here is why.
First, according to current Chairman Ben Bernanke, the Federal Reserve is targeting a “near zero” Federal Funds Rate for another two-and-a-half years until mid-2015. This means a looser monetary policy and, thus, money will pour into gold as a means to hedge against continuous depreciation of the greenback.
More importantly, even after 2015 comes and goes the Fed has no other option but to keep this rate at zero (or at least near zero) for at least two reasons:
One, if interest rates were to rise, the United States government – the biggest debtor in the world – would be completely unable to service the interest, let alone the principal, on its massive debt of over $16 trillion (a figure which doesn’t even begin to take account of future “unfunded liabilities” like social security, and the time-bomb that is state and municipal debt). See the chart below for what happened post-1979 to the interest rate on the 10-Year Treasury Note when Volcker started forcing the funds rate higher. Optimistic predictions are that debt interest will be costing American taxpayers close to a trillion dollars a year by the end of this decade. This makes it nigh on impossible for the Fed to “pull a Volcker” on the gold market without completely capsizing the federal budget.
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The second reason is that if interest rates were to rise significantly, businesses and consumers will naturally start to borrow and spend less, which would then force businesses and entrepreneurs to either slow-down their operations or, unfortunately, cut-back on their work force. Simply put, high interest rates would turn into high unemployment. (See the chart below to see what happened between 1979 and 1981 when interest rates increased: 12% unemployment.)
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Keeping these two things in mind – the amount of debt the US government holds and the precariousness of the unemployment rate – the only reasonable conclusion I can make is that the Federal Reserve must hold down the Federal Funds Rate at zero for a long time.
This means that gold is set to be strong for a long time as well. All thanks to Chairman Bernanke: a gold holder’s best friend.
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