Fixing the Weak Dollar Problem
June 18, 2006
A sense of civic duty again propels me to explain how the Fed can solve its inflation problem.
The Fed is in quite a bit more trouble than it seems to believe. At $700/oz. of gold, the dollar had lost fully 50% of its value from its 1980s-1990s average value of around $350/oz. The dollar has genuinely “gone to $0.50.” The result of this, over time, is that it will tend to take twice as many dollars to buy things, or that prices will double. This process takes quite a while, and if we spread it over 20 years we see that the average price increase per year would be about 3.6%. If we add 1.2% “background radiation”, this implies a CPI of about 4.8% for the next twenty years — whatever the official statistics may say. In practice, I tend to think such an adjustment would tend to be a little more accelerated in the early stages, so we can postulate 4%+1.2% or 5.2% CPI. Add 150bps (a historical average) over this hypothetical CPI to get a typical Fed funds rate of 6.7%, and another 70 bps to give the yield curve some slope, for 7.4% on the long end. (In practice, the long end may be instead flat to inverted due to the economic slowdown associated with the higher interest rates.) This is a sort of exercise to think about the situation we are now in.
There is some evidence that the Fed and “The Powers That Be” are paying more attention to this than they are letting on. The recent selloff in gold/rise in the dollar versus gold was assisted, according to the insider scuttlebutt collected by Bill Murphy at lemetropolecafe.com, by very heavy selling of bullion by the usual TPTB entities. The statistics seem to bear this out: CFTC futures information for June 13 indicates that, over the previous week, the open interest in futures actually increased, meaning that the shorts sold more (TPTB) and the longs bought more (other speculators). This increase in short positions was probably not miners, who have been dehedging quite aggressively since the beginning of the year. Another indicator, the bullion owned by the various gold ETFs now operating around the world, also show an increase in holdings. So who sold? TPTB using leased central bank gold, apparently.
Signs of desperation.
It is hard for me to believe that TPTB would be so dumb as to engage in this sort of foolishness — you don’t become TPTB by being a rube — but there you go. The proper way to go about things would be for the Fed to reduce base money directly, which would tend to lead to both a rising dollar and lower interest rates, especially on the long end. (Since interest rates are rather low already, in practice they would probably stay about even.) Alas, to do this the Fed would have to give up its interest-rate-targeting format, as the interest-rate target would otherwise “sterilize” the base money adjustment, “de-adjusting” the monetary base and leaving it net unchanged. People are really attached to this interest-rate-targeting thing, as we see in Mexico where the central bank was basically forced to go back to an interest-rate-targeting format, from its successful corto system of direct base money adjustment, in large part because of the incessant questions as to what the corto’s effect would be on interest rates!
Like politicians, people get the central banks they deserve, apparently.
Indeed Ben Bernanke should know a little about this, since it is roughly the suggestion he gave to Japan’s central bank some years ago. At that time, he spoke of expanding the yen monetary base directly, instead of using an interest rate target, to counteract monetary deflation, but the same principle works in reverse too.
I suspect this debate may begin to get going soon, but also that events will overtake the discussion process, especially as the dollar sags back toward its $730/oz. lows perhaps toward the end of summer.
If we go beyond those lows, as seems likely though it would take some months to get there, the “next leg down” for the dollar could be quite dramatic. From peak to peak, we see that the latest $730/oz. figure for gold/dollar was 60% above the previous $455/oz. peak of late 2004. Another 60% move would bring us roughly to $1200/oz. To make the math a little easier, we can postulate the situation that would ensue if the dollar went to $1400/oz., fully 75% below its previous $350/oz. 1980s-1990s average. In such a case, given the assumptions presented earlier, we might find prices rising an average of 4%*2+1.2%=9.2%, a typical Fed funds rate of 10.7%, and a long bond more like 11.4% (In practice it would get nowhere near there, and the yield curve would certainly be inverted.) That would be pretty exciting, oh yes indeed.
