Gold and the U.S. Dollar

As an investor, there are two main values of the U.S. dollar to monitor:

1. the international or foreign exchange value of the U.S. dollar, and
2. the domestic value of the U.S. dollar.

Last month's focus report in The View discussed the international value of the U.S. dollar. This month's report analyzes the domestic value of the U.S. dollar.

Gold's plays an important role in our report this month. We rely on the price of gold as a proxy for the domestic value of the dollar. The View this month discusses how the price of gold can be a valuable signal as to the state of the U.S. monetary and fiscal policy. As gold has risen over $225 an ounce in the last 10 months, we believe the domestic value of the dollar has weakened dramatically.

Stock and bond markets have been trending solidly higher in the last few years. Market volatility has been fairly low. Yet the decline in the international value of the dollar and the recent weakening of the domestic value of the dollar tell us that confidence has dropped. If the dollar decline eventually accelerates into an outright collapse as we expect, then the 21st century gold rush has just begun…

The Monetary Feature of Gold

Gold has many unique features compared to other commodities (see Appendix I). These features explain the allure that gold has built up through the ages. The most important feature for our discussion is the monetary value of gold. For thousands of years gold had been used as a metallic form of money. While President Nixon ended the ability to convert dollars into gold in August of 1971, gold today is still a valuable indicator of monetary stability in the global financial system.

Gold registers or measures the impact of government policymaking. It is a reference point to measure the integrity and stability of the currency and the debt issued by a government. As such, it is a sensible guard against fiscal and/or monetary policy errors by governments.

In the United States, the Federal Reserve has monopoly power to create money. Dollars in circulation and bank reserves are created by the Fed when it buys up previously-issued debt of the U.S. Treasury (Treasury bills, notes and bonds). The process converts interest-bearing debt to cash.

The gold price signals whether the Federal Reserve is supplying the correct amount of dollar liquidity relative to the demand for dollars. Therefore, gold is a gauge of the current stance of monetary policy. It measures the constantly shifting relationship between the confidence in the dollar and the value of an everlasting ounce of gold.

An extended fall in the price of gold shows that investors have chosen to exit gold in favor of the dollar. An extended rise in the gold price shows that investors have chosen to exit the dollar to increase their holdings of gold.

Gold is a reliable proxy or substitute for the value of any domestic currency. It is a barometer or signal of monetary conditions. Think of the price of gold as a domestic exchange rate-an amount of dollars exchanged for 1 ounce of gold.

The next page shows a graph of the price of gold since the dollar began to float in 1971.

The Domestic Value of the U.S. Dollar

Last month's The View covered the international devaluation of the U.S. dollar. The domestic value of the dollar has been devalued as well: notice in the chart that the modern day "gold rush" began during mid-2001 when gold bottomed at $250 per ounce. The price of an ounce of gold has risen 192% since then to $730 per ounce just last month. With gold trading yesterday at $640 an ounce, the metal is $275 above its average of the last 20 years, (75% above its long-term average)!

We believe it is no mere coincidence that the price of gold bottomed in 2001. We trace the beginning of the reflationary efforts of the U.S. government to January 2001. That is when former Federal Reserve Chairman Alan Greenspan began his campaign to slash interest rates from 6.5% down to 1%. By mid-2003, the benchmark fed funds rate was cut 13 times and reached levels not seen in 40 years.

The message is clear: gold's recent gains reflect a vote of no confidence in the current stance of U.S. monetary and fiscal policy. Investors are signaling that the U.S. lacks monetary and fiscal discipline. The inflationary impact of monetary and fiscal policies is causing dollar holders to reduce their cash levels and purchase gold. This is evidence of a classic swap as investors look to protect themselves against the government's efforts to create inflation.

Unfortunately, international and domestic devaluation of the dollar increases inflation which ultimately undermines monetary stability. The devaluation path will eventually lead to monetary instability in the next few years with dire consequences for bond and stock markets.

Inflation

Think not of the price of 1 ounce of gold swinging up and down. Think of the domestic value of the U.S. dollar inflating up and deflating down, in terms of 1 ounce of gold. As gold is a signal of liquidity-a sustained price rise suggests a surplus of dollar liquidity. In this way, you can see that fluctuations in the price of 1 ounce of gold indicate liquidity changes in the U.S.

A low price of gold reflects tight liquidity conditions-with deflationary consequences. A high price reflects easy liquidity conditions-with inflationary consequences. An analogy would be a tire pressure gauge that measures the air pressure within a tire. The gold price is monetary gauge that measures the inflationary and deflationary pressure in the U.S. monetary system.

Inflation is usually created when the Fed supplies an excess growth of money that is too high relative to the demand for money. The excess money usually occurs when income taxes are increased to pay for wars, to balance budget deficits and when capital gains taxes are increased. ¹ The demand for money falls as it becomes harder to "make the numbers work" for new projects with higher tax rates. With a relatively constant supply of money in the short-term, the lower demand for money causes the gold price to rise. Investors reduce their holdings of excess money or liquidity by buying gold.

Many define inflation as a period of rising prices. We prefer economist Robert Mundell's definition of inflation: a decline in the monetary standard; that is, the currency's stability, integrity and constancy suffer due to the excess liquidity in the system. ² Viewed in this way, rising prices are a result of inflation.

The more popular inflation gauges like the Consumer Price Index (CPI) and the Personal Consumption Expenditure (PCE) Index are calculated to measure inflation over periods of time that have already passed. The one inflation gauge that is forward-looking is gold. It immediately measures the decline in the monetary standard or a perceived future decline and is evidenced by a rising gold price. ³ Gold's big rise equals accelerating inflation.

What does Ben Bernanke, the Chairman of the U.S. Federal Reserve bank have to say about current inflation expectations? Here is a recent quote:

"…long-term inflation expectations appear to remain well contained." ⁴

Bernanke's response suggests:

1. he is ignoring gold's explosive rise in the setting of monetary policy or
2. he is avoiding a discussion of gold's rise to try to talk down expectations.

We believe either of these to be dangerous to the domestic value of the U.S. dollar. A discussion of gold's meteoric rise would show that the gold market is indicating that inflation expectations are not well-anchored. To restore the value of gold, the Fed should accept that gold is a valuable regulator of the demand for liquidity in the financial system.

The restraint provided by the unambiguous price signal delivered by gold can deliver the stability of the currency that economic agents deserve from the U.S. government; for its main responsibility should be to guarantee the integrity of trade in the marketplace without interference from inflation or deflation. So what are the current inflation prospects in the U.S.? Based on gold's recent meteoric rise, prospects are not good.

Unintended Consequences of Inflation

One of the nastier effects of inflation is the inevitable blame game that takes place as a result of the economic and financial stress that is caused by inflation. The venomous language of the blame game can be destabilizing to financial markets as volatility increases and prices overshoot in the short-term. Here is a partial list of parties subject to blame:

• Companies are blamed for raising prices and firing workers
• Workers are blamed for excessive wage expectations
• Executives are blamed for excessive compensation
• Other countries are blamed for their cheap labor and trade surpluses
• The government is blamed for interfering in the marketplace

The list could go on and on-but the biggest threat to stability from inflation is what follows after: deflation.

Deflation follows Inflation

The worst spillover effect of the U.S. government's recent inflation efforts will be a financial crash of the asset markets. Prices of commodities, stocks, real estate, etc. and then prices in the real economy will undergo a massive downwards re-pricing. In other words, the reflationary efforts will ultimately be deflationary.

Here is what Ben Bernanke, the Chairman of the U.S. Federal Reserve had to say about deflation in November 2002:

"Deflation is defined as a general decline in prices…" ⁵

We believe that Chairman Bernanke's definition is flawed. Our preferred definition describes deflation as a decline in the monetary standard. The general decline in prices is a resultant outcome of the decline in the standard.

Here is what Bernanke had to say about the cause of deflation:

"The sources of deflation are not a mystery. Deflation is in almost all cases a side effect of a collapse of aggregate demand-a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers." ^6,7

Stating that deflation is a side effect of a collapse of aggregate demand allows policymakers a convenient excuse if markets and the economy crash. Policymakers can exclaim that business was good and they aren't sure what happened to cause economic growth to decline.

Even if we did agree with Bernanke's definition, the follow-up question to ask is: "But what causes the collapse in aggregate demand?" We believe deflation is a direct effect of the decline in the monetary standard. The collapse in aggregate demand is a symptom of the deflation. Rather than shifting responsibility for the deflation or blaming investors or suggesting that economic growth just stopped, a focus on the decline of the monetary standard demonstrates that policy errors from the U.S. government are the true reason for the crash.

Gold as an Interest-Rate Signal

We use the gold price along with a few other indicators in our interest-rate model to help us forecast the current stance of U.S. monetary policy. We know that gold moves instantly in response to liquidity moves by the Fed and fiscal policy decisions by Congress and the President. So it affects interest rates with a lag.

Our model incorporates the lagged effect of gold's price to help us determine if Fed policy is appropriate given the market level of short-term interest rates. If the Fed is "late" in raising the federal funds rate (as they often are), our model indicates that monetary policy is "behind the curve." We use the spread between "where Fed rates are" and "where they should be" as a measure of pressure that is building in the financial system. ⁸

Bottomline: The huge jump in the price of gold over the last few months will force short-term interest rates to rise an additional 1% over the next two years, given the current shape of the U.S. yield curve. If we are correct and market rates rise, the key question to try to answer is: "Is the Fed up to the task of raising the federal funds rate another 1%?"

Wrap-up

Gold's price is valuable because it is a signal of domestic value of a currency. As gold has moved up dramatically over the last few months, the domestic value of the dollar has weakened. Eventually the weakening of the dollar will turn into an outright collapse. A spillover effect of the dollar collapse is that short-term interest rates could continue to rise over the next 2-3 years. Additional interest rate increases will eventually tip monetary conditions in the U.S. from neutral (current reading) to bearish. And when conditions turn bearish we expect a financial crash in the bond and stock markets to occur.

For protection against inflation, investors can consider the purchase of a small, core holding of gold bullion. Investors with a higher risk tolerance can consider the diversified gold funds (see Appendix II) or the more volatile individual mining companies (Appendix III). As always, use short-term price weakness in the investment (the price of gold or the share price of the fund or the mining share price) to build your position.

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Thanks and have a great month!

John Wibbelsman, CFA

GlobalMarkets Investment Advisors, L.L.C.

www.2globalmarkets.com

Footnotes

1. The Vietnam War, Operation Desert Storm, the recent war on terror, and the Afghanistan and Iraqi wars are the most recent examples.
2. Robert Mundell is a Canadian economist. He has been a professor in the economics department at Columbia University since 1974. Mundell was awarded the Nobel prize in economics in 1999.
3. Gold also measures the effects of deflation. Deflation is also defined as a decline in the monetary standard and is evidenced by a falling gold price.
4. Response to the Joint Economic Committee Chairman Jim Saxton's April 27, 2006 hearing questions by Ben S. Bernanke, Chairman of the Board of Governors of the Federal Reserve System, May 24, 2006.
5. "Deflation: Making Sure "It" Doesn't Happen Here," Ben S. Bernanke, National Economists Club, Washington, D.C., November 21, 2002. At the time of these remarks, Bernanke was a Governor on the Federal Reserve Board.
6. Ibid.
7. For additional quotes from Chairman Bernanke, see pps. 4-5 of the Feb06 issue of The View available on the Archive Page of the GlobalMarkets' website: www.2globalmarkets.com/TheView/Feb06TV/TheViewFeb06.pdf
8. To read more about the pressures that are building in the global financial system, see the Dec05 issue of The View available on the Archive Page of the GlobalMarkets' website: www.2globalmarkets.com/TheView/Dec05TV/TheViewDec05.pdf