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Effects Of Monetary Policies

December 23, 2014

“Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy. The Committee sees this guidance as consistent with its previous statement that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program in October, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.” Dec 17, 2014; FOMC Statement

That paragraph is the only part of the growing FOMC statement that matters -aside from the sometimes entertaining dissenting votes, in this case three, which didn’t really dissent from the enerally easiest money policy ever; now on its seventh year and counting. I don’t care how many different names it has - QE, ZIRP, twist, liquidity, etc. – it is the longest running monetary intervention in the Fed’s history.

That’s a hard data point.

The rate of growth in US money supply in the post 2008 period, even with a lower than historic participation of the commercial banks, has been more than 50% greater than in its long run history.

It has averaged 11% yoy post 2008 compared to about 7% on average for its longer-term history (including post 2008). I’ve published these graphs often to remind us of just how unprecedented the current situation really is –i.e., the US money supply has doubled since the crisis! So far it’s mostly just gone into asset prices, fooling pundits into confusing damage to the capital foundation of the economy with economic growth (i.e., inflationary rents with profit). It will affect other prices too, don’t worry.

The lags on these things can be great.

The outbreak of price inflation in Russia only started this year, even though its banks inflated way worse (than now) in the years prior to 2008 without any real fallout occurring from it before now.

As we have seen in our own markets, imbalances can be maintained longer than people expect.

I have written about why we haven’t seen an outbreak of inflation (in prices) in the US and/or Canada, yet.

At the risk of deviating too much let me just summarize the main factors in my analysis,

1. Fed tightening cycle 2004-08 produced a demand shock, commodity prices collapsed temporarily
2. Post 2008 money expansion was not as great as we expected even if it is greatest on record
3. Deflation expectations were initially dominant and resulted in cash hoarding post 2008, up to 2012
4. World’s largest banking systems are impaired and have not generally joined in with the central banks
5. Expanding economic output post 2008 likely absorbed some of the effects of money growth

I don’t think we have to abandon economic logic to understand why price inflation has been relatively low in North America -even though it is true that most gold bulls expected it to be higher immediately after 2008.

The Heart of the Matter; Western Governments Have Become Fundamentally Insolvent

What is truly at risk here is THE monetary experiment that started in 1971. It is different than the one that preceded it (1945-71), which was also different than the systems that preceded (1933-45; 1895-1933; etc.).

What makes it so vividly different is that it is only since 1971 that the world has been completely off of some type of gold related standard (excepting the Swiss who abandoned their gold linkage in the nineties).

That’s just a few generations.

When it happened, gold bugs and other free market economists warned of the consequences of a 100% government managed fiat money system. In fact, they’d been warning of the move in that direction for a while before too. After some initial vindication in the seventies - during the early transition from the failed gold exchange standard to the new fangled fiat dollar based international floating exchange rate regime - gold bugs fell into some discredit again when the new system didn’t spiral out of control in the eighties.

Not only did the US dollar survive, but the government continued to thrive, and importantly, to grow.

Year after year the first genre of doom and gloomers warned of the consequences of the accumulation of public debt, back when it was approaching just $1 trillion! They warned of the unsound banking schemes springing up on the back of the new US dollar standard. They crashed. And then got bigger than ever.

The first genre was too far ahead of the accumulation of the imbalances, let alone their peaking points.

Moreover, the liquidation of malinvestments (built up during the sixties’ and seventies’ easy money policies) brought about by the Volcker Fed’s absolute brake on money supply growth bought the new system some time. It allowed markets to clear all previous imbalances and embark on a new growth path regardless of the failure of Reagan either to return the economy to laissez faire (its own management) or honest money.

The Fed talked tough on inflation for several more years but the banking system continued to inflate at a modest pace through the eighties and early nineties, and ultimately Volcker’s credibility was diluted by the Greenspan Put, and later, under Bernanke, a general return to Keynesian style monetary policies like those in operation during the sixties and seventies...all of this inevitable and predicted by the gold community.

But even before, all through the eighties and then the nineties, the doom and gloomers kept warning.

Throughout this period, however, the government continued to thrive. There was no social collapse, and the US dollar’s foreign exchange rate, while often weak, did not collapse either. Although the government and the public debt expanded tenaciously, moreover, stocks climbed ever higher, and the baby boomer generation fell in love with them. Interest rates generally fell, despite constant and incorrect calls by the gold crowd. The dollar benefitted from the fiery implosion of other less sound currencies and the collapse of communist blocs –which contributed to productive and innovative free market forces. By the late nineties it even appeared that the Fed had eliminated the out of control 1970’s inflation once and for all.

Only after the tech bubble – at the height of the “cult of equity” – and the strong dollar policy of the late nineties burst at the seams early in the new millennium did the gold bugs see some indication again for the first time in decades. But otherwise, the narrative for most people is tired and old...even though a few decades is such a short period in the context of how long the world has been on a gold/silver standard.

That’s why even you may be immune to understanding what i am about to tell you.

For, here’s what is different today than it was in the nineties, eighties, or especially in 1978 when Volcker slammed on the brakes for three years and allowed interest rates to normalize (they soared to ~20% in the US...higher elsewhere): the public debt has reached a point where the government cannot afford for the Fed to exit. It has grown practically 20-fold since Volcker’s exit, in dollar terms, and more than tripled relative to GDP. Plus, today there’s a bunch of unfunded debt that is destined to come into play mañana.

The only other time the debt/gdp ratio has been this high in the US was during WWII. Back then, after the war, the US went on a diluted gold exchange standard and the debt was subsequently reduced, especially relative to GDP, as economic policy shifted back to laissez faire again, at least until the sixties. Today the lure for the increase in public indebtedness is not war; at least not any world war, not yet anyway. Today there is a plethora of agendas funded by this roundabout and indirect form of taxation and slavery - i.e., mainly progressive welfare policies supporting the causes of statists on both the left and right of the contemporaneous political spectrum, the war on drugs, the war on terror, and so on.

It has been a free for all for decades. And just as the gold bugs predicted (I became one in 1999). Thank you, Mr. Nixon! For, the incentives are built right into the new monetary system this time.

One of the policies made easier by the less restrictive fiat dollar based monetary order is the Fed’s interest rate suppressions, since it requires monetary expansion -i.e., an elastic currency. This type of policy tilts the playing field in favor of the borrower (and against the saver); it encourages greater consumption at the expense of saving; it also encourages more borrowing than would occur otherwise as borrowers will tend to overestimate how much debt they can carry, particularly if they have a hand in setting the interest rate.

And since, unlike real debt, politicians aren’t putting up their own collateral, it encourages them even further! Call it one of the unintended consequences of the new gold-less monetary system, but this is why debt/gdp levels are off the charts in almost every western developed nation that is party to this monetary system. The consequence of all this is that the Fed and its biggest customer cannot afford to exit the current policy in almost any form. And it certainly cannot afford a Volcker style abandonment of the Fed’s paradigm. Please don’t underestimate what this means. It means they are now trapped by the policy.

No reset, like that which occurred under Volcker, is possible today. They have to keep inflating in order to keep interest rates from normalizing. Today, with the debt/gdp ratio three times as high as it was at the dawn of the current monetary order, a mere 8% interest rate could bankrupt the US government -with almost all of its revenues going to the payment of interest at those levels. Indeed, when we say that these governments are insolvent we mean that they can no longer afford to abandon the inflationary paradigm.

They survive now ONLY by robbing Peter to pay Paul. This has not always been the case! It is new!

Although the warnings are old.

But the day those warnings warned of has arrived, and the evidence is the central bank’s fear about exiting, let alone abandoning the policy. We’re seven years into a boom and they haven’t even started to tighten!

You can see the inflationary ideology entrenching, as well as the higher long term money printing rate.

There may be several ways to postpone the reckoning but there is only one way to clear it.

Nothing short of sharp meaningful spending cuts (double digit percentages here to start with), massive privatization schemes, debt repudiation (between governmental departments), tax cuts, and getting rid of the Fed will do. The last one is most important as it supports the system that produced a government that has become an enormous parasite on a host (the economy) that has seen its capital severely impaired.

But these aren’t popular fixes. They won’t be popular until we are inundated with a price revolt -which, once it arrives, they won’t be able to stop because they can’t afford to stop printing and normalize rates!

And that’s what we mean by TEOTMSAWKI.

Are Those Dead Canaries and Butterflies Flapping on the Horizon?

Oil and gas prices continued to collapse earlier this week, putting further pressure on the energy producers, and their downstream factors. Russia’s central bank raised rates sharply in reaction to the Ruble’s collapse. And China tightened just the week before. So far these ripples have done more to support the Bund and UST’s. For much of 2014, the monetary backdrop has been one of lessening “stimulus” in the largest economies - although the ECB and BOJ are aiming to change that in 2015 - but of increasing money growth in many of the emerging economies (Turkey, Israel, Hungary, India, Mexico and some of the South American countries, South Africa, etc.), which has benefitted the US dollar.

Perhaps the biggest question for the short term is whether the oil price decline works in favor of wall street or whether, since it was related to a sector specific boom, it is a canary, or omen of impending doom (for the more general boom in stocks, and particularly government bonds).

I think it has to be viewed as a canary, and I think the situation in emerging markets should be viewed as an example of what is to come to the shores of the more advanced economies when those little waves merge with the rolling tsunami. Perhaps the Fed’s rhetoric indicates that it agrees with our assessment, or else it would have taken the oil price ‘cut’ as an opportunity to withdraw the “considerable time” phrase and at least hint towards an exit. Instead, however, ostensibly reacting to lower inflation expectations, stagnating real estate values, and perhaps worried about some of the dead canaries in the global economic pipeline, the Fed decided to put off withdrawing the inference and asked investors to be patient with it about its decision to withdraw ZIRP and to begin some kind of policy toward interest rate normalization.

[We have been daring them since 2009, btw.]

The next day the Fed also announced a 2-year extension of the Volcker rule on private equity for the big investment banks (up to 5 years for some of the smaller ones), thereby postponing the liquidation of billions of dollars worth of those assets. The Dow rallied over 400 points on the day of the news, and the day after the FOMC pump and dump, ultimately halting the precious metals recovery in its tracks.

Is the Fed’s rhetoric and Volcker rule delay going to be enough to forestall the bust we have been looking for? Will the ECB and BOJ come through and re-inflate as expected in 2015? And if yes, will it be too little too late? Have the markets gotten too far in front of it? These are questions i too am pondering.

Is Russia Selling Gold to Defend Ruble?

Further weighing on precious metals values last week were rumors that Russia was selling some of its recently acquired gold reserves in a panic to hasten the slide in its currency, which has accelerated recently. The speculation arose because Russia reported a small decline in f/x reserves for November (a few billion dollars), and then larger ones of over $100 billion in the first two

weeks of December. The central bank had accumulated about $415 billion in foreign currency reserves through November with gold representing about 10% of its total holdings. Bloomberg reported on Friday that it did NOT sell any gold in November despite the drop in the value of its foreign exchange reserves that month. Instead, it continued to buy despite the Ruble already being down a lot.

It remains to be seen if Russia has sold any gold in December given the much larger sales of currency reserves reported. If they sold 25% of their total currency reserves to defend the Ruble it is hard to believe they wouldn’t have sold some gold. Most of the street thought it had. So the first thing i have to say about it is that it’s in the market! But I’d be surprised if Russian authorities sold more than the bears expected.

So far its accumulation of gold has appeared to represent part of a long term strategy of some kind.

Moreover, common sense dictates it would be a quickly defeated strategy, with minimal benefit. It makes far more sense to sell dollars and euros and/or other currencies before selling gold. We have to assume that Putin is aware of the likelihood that selling its gold would benefit the US dollar more than the Ruble.

Buying gold on rumors of Russian selling, or news of minor gold sales, is the prudent strategy.

What Caused the Ruble’s Collapse?

Perhaps the Ruble’s slide was catalyzed by the oil price collapse, but its cause lay elsewhere.

Some analysts, claiming that the Ruble is sounder than the US dollar, have argued that the collapse is undeserving, or that it was designed by US neocons to force Putin into compliance over the Ukraine and other foreign policy issues. Bloomberg blamed it on Putin’s gamble to fund his forays into the Ukraine.

Every single one of those views is gravely mistaken.

You all recall my view on the Ukraine. The US media simply reports information it gets from Washington, which tends to contradict much of the news from independent sources on the ground and online. I do not believe their portrayal of Russia as aggressor, and I believe that the US/EU/NATO alliance is overstepping its bounds with its own influence of affairs in the Ukraine and its cover up of the violent coup that started it.

Granted, the Ruble’s crash could be overdone, but I will stop short of recommending Russian investments.

I have heard that Jim Grant on the other hand likes Russia. He may know something about where Russian economic policy is headed. I don’t. All i know is what kind of policy led to the current collapse of the Ruble.

Russian Monetary Policy

Last year i looked at the emerging markets situation because the Indian rupee was falling out of bed, and the financial illiterates blamed it on the Fed’s plan to taper in combination of the want of Indians to buy gold and other goods the poor Indian economy cannot provide -so it is at the mercy of foreign exchange traders.

However, I argued that India ran an aggressive monetary policy, which it continues to this day, and that the effects were just coming home to roost. In September 2013, I showed that “India had the second highest rate of price inflation (over seven years) out of 40 of the largest countries on the planet covered by the OECD – behind Russia – and that it ranked 8th in the same group in terms of how much it expanded M1.”

In the same report I wrote:

“...the other four currencies having trouble (Turkish Lira, Indonesian Rupiah, Brazilian Real, and South African Rand), dubbed the “fragile 5”, ranked similarly high in the dishonesty of their monetary policies in a group that will probably expand to include the Ruble, the Icelandish currency, the Mexican and Chilean Pesos, and maybe even the Chinese Yuan. All of these countries are guilty of inflationary monetary policies that are frankly many times worse than their counterparts at the Fed.”

I showed this clearly with the following chart comparing M1 as indexes all starting from a base of 100 in the year 2000 and ending in 2013 (source: OECD). Turkey and Russia lead the long term 10-15yr rankings.

In February this year, based on a similar ranking, and still pretty much before this collapse even started, I wrote that, “The next worst offender of the sound money policy over the last 10 years was not the Fed. It was Russia. After that it is Iceland, Israel, Chile, and China...In Russia, the central bank’s first deputy recently admitted that a number of countries, including Russia, were going to experience a bout of stagflation. But likewise there, “Consumer prices grew 6.5% last year, above the 5%-to-6%...”

There you have it. Recall our rankings, updated through to Aug/Sep 2014, from the OECD.

Note that Russia has fallen down the list a little and that it has slowed the growth of M1 more significantly than many other countries, especially in the post 2008 period. However, it is still inflating faster than many other countries - and at least as fast as the US. While that is down from annual rates of nearly 50% year over year in the period leading up to the 2008 economic crisis there is one important point to make here.

Because of the US dollar’s weakness in the 2002-07 period, a lot of countries got a free pass on their very unsound monetary policies, and they took advantage. Indeed, when i saw that happening i knew the US dollar would soon bottom. However, although the Russians had inflated their money supply by four or five times as much as the Fed, the currency had fallen less than 20 percent against the US dollar in this period.

Clearly something has been due, particularly when price inflation started to show up earlier this year. It is probably overdone now. I don’t know. But the cause of this debacle can no more be blamed on US conspirators than we can blame the Rupee’s collapse on gold importers. It’s their own economic policies. There has been weakness in the Lira, Peso, Rand as well as the Rupee (more might be deserved), but currencies like Hungary’s Forint and the Israeli Shekel are overdue for a hit based on this data alone.

But so is the USD, which is far too high in the rankings above for a reserve currency issuer.

Russia Made its Choices

The US debt/gdp ratio is the third highest of the G20 behind Japan and Italy, and basically one of the highest in the world...almost as high as the worst of the European countries involved in the EU crisis.

Russia today has one of the lowest debt/gdp ratios: less than 10%.

The interesting thing is that it has fallen from nearly 100% before its massive inflation from 1999-2007.

That is, the Russians faced their demons and instead of liquidating the state they hyperinflated the public sector debt away. Sooner or later that had to come home to roost on its exchange rate.

What will the US and European countries do?

Probably the same.

********

Source: Ed Burgos: www.dollarvigilante.com

Ed Bugos is a mining analyst, investment banking professional, and senior analyst at The Dollar Vigilante (an online guide to surviving the dollar crash), with more than 20 years experience in the investment business advising clients on portfolio and trading strategies.