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March 27, 2005 – Recent statements emanating from last week’s Federal Reserve Board meeting roiled the markets. Since all eyes are focused on the Fed, this is nothing unusual. However, while the stock and bond markets responded to their inflationary concerns as should be expected, the fashion in which various other important markets reacted read like a chapter from “Alice in Wonderland”.

The Federal Reserve stated that, “Though longer-term inflation expectations remain well contained, pressures on inflation have picked up in recent months and pricing power is more evident”. This statement came a day after the release of February’s Producer Price Index and the day before the Consumer Price Index was announced.

Not surprisingly, the PPI and CPI both showed significant price increases. February’s PPI rose 0.4% which following January’s 0.8% rise. These were largely the result of soaring oil and numerous commodity advances that had already propelled the CRB Index to a 24 year high. Further, February’s CPI increased by 0.4%. All of this occurred while bond yields were rising. They began a rapid ascent several weeks earlier, indicating their fear of potential inflation

The above factors were already well known by the marketplace. Yet, the Fed’s belated acknowledgment of this reality suddenly seemed to awaken the masses and move the markets into action.

Immediately upon receiving the judgment of the Fed, turmoil spread from market to market. Common stocks and bonds plummeted, oil and gold were trounced, but the dollar staged a rally.

For those who understand how inflation influences the markets, the declining actions of only bonds and equities should have resulted from the statements uttered by our monetary leaders. However, as if scripted directly from a fairytale, the other inflation sensitive markets while they should have soared, were instead hammered lower in price. The fact that the dollar strengthened only added to the wonderment.

Under ordinary circumstances the threat of inflation frightens certain markets while it emboldens others. However, in this instance, all those that one would expect to be positively influenced by the Fed’s new inflationary concerns, weakened in unison. On the other hand the dollar, which should have been aggressively sold, rose skyward. To my mind, this created an incredible disconnect between the worlds of reality and fantasy. I’ll explain.

The primary reason why the fear of inflation negatively influences bonds, equities and the dollar is due to its effect upon interest rates. Rising interest rates are a byproduct of inflation. They result when bond buyers demand a greater rate of return. They hope this will compensate them for assuming the added inherent risk to which inflation exposes them.

Inflation reduces the dollar’s purchasing power; it takes more dollars to acquire the same things as before, so each dollar is worth less. This recognition drives bondholders to protect themselves. They feel threatened that the return of their invested funds will purchase less when they sell their bonds. This instills fear into their hearts. It moves them to refrain from committing to purchase additional domestic interest bearing securities. That is, until they are offered sufficiently higher interest rates to offset their new risk.

Unrecognized by most investors, inflation not only damages the economy and fabric of a nation, but also the way of life of its people. Rising prices are rarely accompanied by similar increases in wages. The higher prices place great pressure upon the nation’s masses in their effort to support themselves and their families. This results because the increase in the general price level outpaces their ability to pay for the necessities of life.

Further, as prices rise in a nation state its economy falters and its citizens purchase less. They become priced out of an increasing number of domestic markets. Business slows further, and layoffs become widespread.

Also, their monetary unit begins to fall on the world’s markets as the demand for it weakens against other currencies. Foreigners no longer need it to purchase their goods which could be acquired more cheaply from other lands.

In order to return strength to the falling currency, and to attract domestic and foreign purchasers for their debt, the country’s interest rates begin to increase across the entire debt spectrum. This places added pressure upon the local debtors by increasing their borrowing costs.

As their currency depreciates against those of other countries the local cost of imported goods rises. Similarly, commodities also increase in price, and raise the final cost of the goods for which they are used. These events further exacerbate the rising price structure and compound the problems that have already begun to work their way through their society.

If prices are allowed to spiral higher, the suffering of the country’s citizens will escalate. Not only can a business slowdown cause layoffs to soar, but the cost of living can reach a level where life’s necessities move beyond the range of an increasing number of their inhabitants.

This will only be intensified by the debt burdens which can become smothering. The rising monthly payments limits people’s disposable income, and must first be met before any other expenditures are contemplated.

When prices escalate the purchasing power of one’s life savings simultaneously deteriorates. The way of life that the country’s people scrimped and saved to enjoy moves further and further out of their reach. Retirement plans are dashed because savings can no longer pay for the necessities and other items that they were expected to and once could cover. Common courtesies and any concern for others fades as their citizens become consumed by their thoughts and fears for their own survival. This causes them to overlook those around them. Crime increases because some suffering individuals feel compelled to take from their neighbors in order to survive. Finally, these events enter a damaging downward spiral.

Not a pretty picture, inflation!

So what was so surreal about the reaction by some inflation sensitive markets to the pronouncements of our Federal Reserve Board members? To my mind, the only markets that reacted as they should were the equity and bond markets. They plummeted, and rightly so! For the others, they all went in directions that would have been more fitting if this played out in an episode of  “The Twilight Zone”. Had the Federal Reserve Board made a similar announcement during gold’s great 1970's Bull Market, the dollar would have sharply sold off and gold would have experienced an excited rise.

The reason given by the media for the strong dollar rally was, as a New York Times subtitle read, “Higher Interest Rates Strengthen the Dollar”. All things being equal, it is true that higher rates will make a nation’s currency more attractive compared to competing ones. However, conditions were not equal. In light of potentially rising inflation, the fear of the currency’s reduced purchasing power should greatly overshadow the minor positive effect that “measured” rate increases offer. It should act to panic people into selling their dollars for the reasons given above, not into buying them.

When the Fed made their pronouncement, gold and oil immediately fell in after hours trading. When the commodity markets opened the next day most followed suit and fell in price. At the first opportunity, aggressive selling hit all of the historically inflation benefiting markets. Simultaneously, aggressive buying entered the dollar market and carried it higher. Given the implications of the Fed’s statements, it boggles the mind that both gold and oil immediately met forceful selling pressure while the dollar attracted huge buying interest. Why?

For the past few years, the Gold Anti-Trust Action Committee (GATA.org) spearheaded by Bill Murphy, has highlighted numerous unusual attacks on gold. These typically occurred in the aftermath of similar bullish gold and bearish dollar news. Mr. Murphy has repeatedly brought these disparities to the attention of his readers. He believes that they are not normal market occurrences. It is his contention that the Federal Reserve or the U.S. government have been managing the gold and dollar markets in a similar fashion as they have interest rates.

Gold is anathema to politicians. It forces them to act in a fiscally responsible fashion. Since the beginning of civilization, whenever a government abused its monetary unit, gold acted as a warning signal. It’s rising price loudly announced that all was not well with the country’s money.

In1961, the U.S. and seven other nations formed the “London Gold Pool”. It’s acknowledged mandate was to maintain the gold price. Whenever gold rose they sold the yellow metal into the market to return it to its fixed $35 price. They continued in this fashion until the spring of 1968. This is when the market overwhelmed their efforts and, in a matter of two days, drove gold from $35 to $44.25 an ounce. Inflation was in the 3% to 4% range during this period, and the governments were more open about their gold market intervention policies.

If Bill Murphy and GATA are correct government sanctioned management of the dollar and gold does indeed occur at minimum, at critical junctions. Further, it is likely that the surreal action of the dollar, gold, and possibly oil have just witnessed the government’s hand in action.

On a positive note! If this is truly the correct analysis for last week’s dollar, gold and possibly the oil market’s price actions, it may not have entirely negative implications for long-term investors. Certainly futures traders and margined gold holders will be damaged. However, gold equity and physical gold investors will be given the opportunity to increase their ultimate profits. This will occur because the eternal metal’s Bull Market will be extended by our government’s intervention. It will not only last longer but it will be driven to greater heights. In effect, their efforts to retard gold’s rise will give us a longer opportunity to add to our positions, and to benefit from a higher gold price than we would have otherwise. Unfortunately, we will be forced to endure the fall-out from the causes that will drive gold to its final peak.

In any event, for all those trading the gold and dollar markets, be forewarned. Be prepared for similar attacks at crucial points or for announcements that are accompanied by surreal price movements in the dollar, gold, bond and other inflation related markets. Their repeated occurrence will likely continue.

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