How will the Federal Reserve’s actions affect the price of gold?

When I look at the policies that central banks are adopting today, everywhere, I see an inflationary epidemic that is feeding on itself and confirming the bull market in gold.

In the US arguably an epicentre of the modern global monetary system I see a central bank whose powers are constantly expanding. This progression dates back to its birth in 1913, but as recently as 1999 and 2003, parts of the Federal Reserve Act were rewritten and the Fed was given more power to create money.

Today, with progressive calls for action in the face of crisis, the Fed's tentacles are potentially reaching directly into the credit and securities markets. This week alone, the headlines are rife with news of its "sweeping" new powers under Treasury Secretary Hank Paulson's "plan."

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The Federal Reserve is in the midst of another historic interest rate-cutting campaign. Its official policy stance is that it recognizes the inflation risks, but worries more about growth, so it will inflate to sustain "growth."

Money's growing on trees

Its message has been, more or less, that money grows on trees, which is why Ben Bernanke's moniker, "Helicopter" Ben, is catching on with the press. Gold bugs could not be more thrilled. Just recently, I wrote that we are seeing the best of all worlds for gold to shoot straight up a few hundred points.

But wait! "It's not such a sure thing." At least that's what I thought I heardfrom a voice in the wilderness. "What do you mean it's not a sure thing? Look at em flood the markets with liquidity. $100 billion here, a few hundred there."

As I was about to sign off, the voice continued: "No, they are not inflating. They're just creating confidence in the credit markets. Look at the money' numbers," said the voice. "Forget credit. Look at the level of bank reserves and the adjusted monetary base. They haven't grown since August. The Bernanke Fed is just pretending to inflate!"

Disinflation?

Perhaps I already knew what the voice was telling me. Like the title character in Tolstoy's classic novel, The Death of Ivan Ilych, I was doing some soul searching and discovering hidden truths buried deep beneath the surface. The voice was my own, and it was telling me something I had yet to consider.

It has not escaped my attention that the narrow constituents of money supply are not expanding. I've written about it.

This disinflation was first apparent as far back as 2005, under Alan Greenspan's tenure, when M1 growth hit zero percent on a year-over-year basis. He set it in motion through the rate hike campaign. The total value for US M1 has not changed in three years. But our "voice" insists that Bernanke is running a different, more deflationary policy than Greenspan even though under Bernanke's reign, since 2005-06, the broad credit aggregates have reaccelerated and the tightening campaign abandoned, and reversed. Clearly, the Bernanke Fed is running a different policy.

But it is difficult to call it a more deflationary one.

Bernanke's Fed

Okay, so it has kept M1 flat, and slowed the growth in the monetary base a wee bit further (which has no doubt contributed to the crisis). And since August, the Fed has not expanded bank reserves overall, even though it has slashed its policy-setting interest rate by 300 basis points, has taken other measures to ensure short-term liquidity and talks as if it is ready to underwrite almost any insolvency.

We may point out that if the Fed wanted deflation, it would have already arrived. If, for example, Bernanke actually did nothing, the monetary base would have probably shrunk.

At a minimum, the Fed is inflating just enough to replenish erosion in bank reserves and the market's confidence. The thrust of all of its actions has been to cheapen money and credit and inflate.

That is not to say there aren't any deflationary forces in the system just not ones produced by the actions of the Federal Reserve System so far. If there is deflation in the system, stable money proves the Fed is inflating. If it were pursuing a deflationary policy, you'd have seen a few more Bear Stearns by now and it is unlikely that the broader credit aggregates like M3 and money with zero maturity (MZM) would be expanding so furiously.

Sure, there is a run on risk, and this risk aversion is causing some asset deflation, which in turn is producing a lot of short-term liquidity. So the Fed hasn't had to create a lot of net new notes to push rates down, yet. Consequently, so far, it is merely underwriting a lot of the market's current confidence, rather than monetizing it. But it does not necessarily follow from stable money supplies that the Fed is deliberating a deflationary policy.

Quelling the rising price of gold

So deflation has not set in yet, but our normally credible source is still convinced that Bernanke is secretly pursuing a policy of deflation while pretending to inflate. But from the central bank's point of view, the costs of such a policy are prohibitive. So why am I still listening to this "voice"?

Because it believes the Fed wants to hijack the gold market In other words, the Fed is trying to quell the rise in the gold price.

A central bank's general incentive to dampen gold fever is a given, but why would it want to so bad that it would be willing to risk political suicide? Our voice explains that some of the large bullion banks still hold massive derivative short positions in gold, which they borrowed from the central banks to sell into the market in the 90s. We have not heard any of them report large losses on those positions yet. They are potentially huge.

But are they huge enough to motivate the Federal Reserve to orchestrate a deflation policy in order to save these banks from ruin? The last genuine deflation in the US (1929-33) wiped out almost all the banks. Are you telling me that the gold shorts held by a few select bullion banks can cause more total pain than a deflation policy?

I doubt it, especially since the central banks are so forgiving on the terms of the gold loans.

A balancing act?

So, this voice is right that the Fed is not expanding narrow money, but it is wrong about the Fed targeting deflation.

And it should be. Bernanke may well be trying to keep the monetary base stable to discourage speculation in the gold and oil markets, while at the same time boosting confidence in dollar-denominated assets.

This kind of a balancing act (or "sterilized" inflation) is not foreign to the Fed's modus operandi. In fact, it was well accomplished by Bernanke's predecessor.

While the idea that the Fed is deliberating deflation in order to undermine gold makes little sense, the fact that the monetary base is not growing is relevant and deserves further monitoring. Regardless of the explanation, when the central bank is not inflating, it is not bullish for gold. I say this even though, empirically, the relationship between money (i.e., M1) growth rates and gold prices is not cut and dry.

Gold prices would fall in a monetary deflation

If you bought and sold gold based on the requisite changes in M1 growth rates, you'd be on the wrong side of the trade most of the time, at least since the 80s. You'd have turned bearish after 2004, missing the last $400 rally. It is important to monitor. But we live in a global world today. The effects of inflation produced by China's central bank are felt in America, and vice versa.

It's especially a bad idea to short gold. But it is a good time to pick away at values created by the "Chicken Littles" on the way up to $2,000 if you believe that the Fed is inflating.

I'm not going to tell you that gold is going to go up whether we have deflation or more inflation. I don't believe that. I believe gold prices would fall in a monetary deflation. But I don't expect one soon.

By Ed Bugos for Whiskey and Gunpowder