The Federal Reserve in the 1920s had a monetary dogma, real bills doctrine, that would ultimately be part of the problem. Today, the current Federal Reserve leadership has another dogmatic problem.

Monetary policy in the United States appears today to be based on erroneous measures of inflation and the assumption that money may not have anything to do with inflation. Little argument exists on the faulty character of the U.S. measures of inflation, which suggests a more productive discussion would be of the apparent view of the role of money in the creation of inflation.

Money, how much of it exists and where it resides, seems to play little or no role in the setting of policy by the Federal Reserve. Somehow at the meetings of the FOMC, a divinely inspired forecast of future inflation arrives. Then, using their special talents and insights, the members of that committee select a federal funds rate that will somehow cause their preferred level of inflation to arrive. The federal funds rate goes into a magic black box and out the other side comes the desired inflation. Essentially, the process is magical rather than fundamentally grounded. A divining rod has more theoretical physics behind it than U.S. monetary policy has sound economics.

Somehow a connection exists, in the minds of the FOMC, between today’s Federal Funds Rate and future inflation. We are not told what might be the transmission mechanism. Some mysterious and undisclosed connection exists between them. Apparently ignored is that inflation is the number that results from the deterioration in the purchasing power of a national money caused by excessive creation of money. That connection is either ignored or rejected by the current Federal Reserve leadership. The root of the monetary plant that produces inflation is ignored in favor of some mythical or mystical connection between today’s Federal Funds rate and tomorrow’s inflation rate.

Not all central bankers share this “new age” view. Jean-Claude Trichet, president of the European Central Bank recently wrote,

“At present, the dominant academic view seems to be that monetary aggregates should have no part in monetary policy decisions. From this perspective, money does not deserve to be central to one of the two ‘pillars’ of the ECB’s monetary policy strategy. I do not share this view. In this I follow Friedrich Hayek, who wrote in The Pure Theory of Capital: ‘it is self-contradictory to discuss a process[inflation] which could not take place without money and at the same time to assume that money is absent or has no effect.(Trichet,2006)’”

Those writings were Trichet’s little jab at central bankers that ignore the creation of money in the consideration of inflation. Inflation is by definition the creation of money. If additional money is not created, prices, in general, could not rise. Relative prices of goods, bananas versus oranges, might change, but the general price level could not rise. Inflation is the degradation of a money’s value by excessive creation of money. Inflation is not some separate economic force that lives in isolation.

These comments in part are a criticism of the Federal Reserve that acts and talks as if no connection exists between the quantity of money and inflation. According to chalk board economists, like Bernanke, inflation is some primal force with its own energy. In the chalk board world, raising interest rates and esoteric discussions of productivity nuances will keep inflation bounded within some desirable range. The connection between interest rates and inflation is unexplained in the Federal Reserve’s mythical world, but is assumed to exist.

If the connection between today’s interest rates and tomorrow’s inflation is not explainable, then tomorrow’s inflation rate is not controlled. Tomorrow’s inflation rate becomes some near random variable. In short, Bernanke’s apparent approach to monetary policy is the combination of two components, delusion and the unexplained. While this may give the Street great confidence in paper assets, others might find it troublesome that no theoretical grounds exist for U.S. monetary policy.

The manifestation of inflation is difficult to define correctly, and is a near impossibility to measure. In the purest sense, the increase in a nation’s money supply is the truest measure of inflation. Any increase in the size of a nation’s money supply reduces the value or purchasing power of that money. Other forces may be at work that are deflationary. The net of those forces is the nation’s realized inflation rate. Whatever the results of the commonly used measurement methods, any increase in a nation’s money supply is inflationary.

Generally accepted is that the estimates of U.S. inflation, consumer price index(CPI) in particular, produced by the U.S. government are statistical stillbirths. Much misguided attention is focused on the CPI less food and energy. This measure excludes the negative aspects of, for example, China’s demand for oil pushing up oil prices. However, it includes the positive benefits of China’s production, using that oil, of goods at low or lower prices. In short, the CPI does not measure inflation but rather how some statisticians view the world.

Some researchers have attempted to produce measures that are more useful than the popular ones. For example, the economic research staff at the Federal Reserve Bank of Cleveland produces a median CPI measure. This index is built on the median change in the components of the CPI. As is often the case, the median gives perhaps a better indication of central tendencies than other measures. The median CPI is included in the first chart as the solid line. Also plotted in the first chart is the headline number of the U.S. CPI, using red squares. Finally, the triangles are buy and sell signals on the headline CPI created using the difference between that measure and the rate of change in the median CPI.

First thing to note in this chart is that inflation, using the CPI, cycles from low to high, and vice versa. When inflation is low, it is likely to rise. When inflation is high, it is likely to slow. This simple view could change under certain conditions, but it seems to describe the experience of the past few years. Investors seem to believe that the recent low rate of reported change in the CPI will continue indefinitely due to the influence of Bernanke’s “magic box.” That expectation is contrary to the picture in the chart, and is composed of more hope and dreams than reality.

The headline CPI measure went to a new high about a year ago as oil prices rocketed upward. That measure has now declined as oil prices have moderated. A different picture is apparent from the median CPI. That measure has continued to rise, and is approaching a new high for the almost ten year period of time shown. Now as oil prices are more tempered, the headline CPI is running at a depressed level.

In the past two months buy signals have been generated by this indicator on the headline CPI, as shown in the first graph. While no real change is taking place in the true rate of inflation, as suggested by the median CPI, the headline CPI is likely to move dramatically higher in the year ahead. Such action may seriously damage the goldilocks economic forecasts. The bears in the story may come alive in 2007. One bear will be inflation and the other bear a recession. Third bear will be ravaging the hedge funds and their derivative portfolios.

That the headline CPI is likely to begin rising at a faster rate in the coming months is important to Gold investors. Such action attracts investors to the Gold market. The scent of higher inflation in the headlines causes investors to seek out safe havens from the ravaging of their wealth by politicians. Rising headline inflation is likely to help Gold break out of the recent trading range.

The second chart combines those buy and sell signals on the headline CPI with the monthly average price of $Gold over the past 34 years. While all indicators have some flaws, this one has had an interesting history. The two sell signals in the preceding year came as reasonable warnings of the slow down in Gold’s price rise that was soon to arrive. Recent signals suggest strongly that the environment ahead will be one in which the inflation picture will draw investors to Gold. Today, complacency on inflation is near universal in the investment management world. They have been lulled to sleep by the Federal Reserve’s mythical inflation control mechanism.

The picture painted above is positive on inflation as it applies to Gold. Real question in the years ahead for the inflation outlook is with the value of the dollar on world markets. A falling value for the U.S. dollar will push up prices in the U.S. Interest rates will likely go up in the U.S. during 2007 as global markets control interest rates, not the Federal Reserve. Collapsing values for mortgage debt will ravage the financial system. Any way one paints an impartial forecast for 2007, it will be good for Gold. Only real question remaining is on what days to buy it.

As shown in the above chart, $Gold has recently passed into a seriously over sold condition. Gold has generally gone on to rally about from these over sold conditions. When Gold rallies from these levels, it is likely to move above the $650 level. That action should bring on more buyers, and set the stage for a run to $700. Silver, as shown in the last chart, is also rapidly moving toward over sold. While not yet at a buy signal, prices in the Silver market at these levels should be used to add to holdings.

Yesterday’s policies are what determine today’s investment opportunities. As a consequence of those policies the world holds too many dollars. Therefore, the only reasonable direction for $Gold is up. To expect the world to continue buying dollars indefinitely is unreasonable. To expect that Goldilocks will bail out the system is both naive and self serving. Purveyors of paper asset strategies may find a strong need for the confessional in 2007. The rest of us will continue to ride the Gold Super Cycle to $1,400.

References:

Trichet, J-C. (2006, November 9). Why money has a vital role in monetary policymaking. The Financial Times, p. 15.

-- Posted Wednesday, 20 December 2006 | Digg This Article