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The Fed
September 23, 2005

The beauty of being a long-term investor -- as opposed to a short term trader -- is that I can take my eyes off my computer screen for more than fifteen minutes without experiencing an anxiety attack. September has been a hectic month thus far with a conference in Las Vegas, one in Deer Lake Newfoundland, the Denver Gold Forum coming up next week and the Toronto Investment Conference shortly thereafter. I have spent very little time at home and far too much at airports and hotels, which is why these commentaries have been scarce lately. But, as I said, being in the market for the long term has its benefits: the fact that I did not have time to analyze each day’s change in the gold price caused me no discomfort whatsoever.

We all know that the US is in the midst of a real estate bubble, however, home construction fell for the second month a row and permits for new buildings also declined in August. The National Association of Home Builders’ index for sales of new, single family homes fell in September indicating a decline in sentiment among US home builders. Freddie Mac also reported that 30-year fixed mortgage rates are on the rise again and the supply of new houses for sale is increasing, in other words the houses are not selling as fast as builders anticipated. At the same time the median price for a new home fell in July. Could the real estate market be showing signs of a top?

Although less discussed, both bonds and equities are at lofty levels as well. Predicting the exact time when a bubble will burst is impossible, unless you’re just lucky, and so we will only know in hindsight when the turning point occurred. But with all that’s going on, the risk of staying in the stock market, owning long-term bonds, and speculating on real estate seems just plain stupid.

Now let’s look at the Federal Reserve Board’s actions of late within the context of these risks. This week the Fed raised the overnight rate for the eleventh consecutive time. Officially, the Fed says that the risk of inflation is greater than the risk of hurting the economy by raising short-term interest rates. But the market disagrees and buys bonds, which is why long-term interest rates have been falling even though the Fed has been raising the overnight rate. Since Katrina, however, long-term interest rates have been on the rise. This could be seen as a harbinger of inflation as the country attempts to cope with rebuilding a city and the impact that higher gasoline prices will have on the economy and prices.

So the Fed is worried about inflation. But which inflation? Are they worried about the increase in the money supply or are they worried that higher gasoline prices will ultimately lead to higher consumer prices? Remember, inflation is an increase in money supply that can lead to an increase in prices. An increase in prices is, by itself, not inflation. So if the gasoline price rises because a hurricane shuts down production that is not inflation. Similarly, if the price of oil goes up because the US dollar fell on foreign exchange markets, it is not inflation.

Surely the Fed has to be concerned that its policy of raising interest rates could hurt the US economy by deflating the real estate bubble and slowing economic growth. In fact, the abuse of leverage in the US real estate market and the extent to which consumers, corporations, and the government itself, are indebted should raise the risk of a deflationary collapse if interest rates keep rising. Especially if long-term interest rates start rising as well, which it appears they may have started doing. So how can the
Fed justify its policy of increasing interest rates?

According to the Fed its policy is to raise interest rates to a neutral position -- the interest rate at which economic growth is neither promoted nor hindered. Currently, the Fed believes that interest rates are still promoting economic growth, in other words, interest rates are too low. How does the Fed know what interest rate is optimal? It doesn’t. The Fed doesn’t even know what money is! Alan Greenspan admitted that crafting monetary policy is problematic because the Federal Reserve does not know how to define money or how to measure it. If the Fed cannot even define, never mind measure, what money is, how can it possibly be so sure that it knows the optimal interest rate at which the economy is neither hindered nor stimulated?

I suspect that the Federal Reserve Board Governors know they have a problem. Could it be that they are worried about something much larger than the devastation caused by Katrina, the impact of higher gasoline prices on consumer spending or a slowdown in real estate spending due to higher interest rates?

The US consumption binge, from stocks, bonds and real estate to the money we spend in our malls on credit cards, is being financed by foreign capital. Cut off the influx of foreign capital and you basically switch off the life support of a terminally ill US economy. Sustaining foreign appetite for US financial products is arguably far more important than anything else affecting the US economy at the moment.

Now, if the US dollar were to decline on foreign exchange markets then foreign investors could start losing money on their US investments even if their US investments are not losing money in US dollar terms. And if US investment returns go south then the losses to foreign investors are compounded.

A falling US dollar would also stoke an increase in prices and, if you (erroneously) think that higher prices means inflation, then you could say that a falling US dollar will lead to inflation. Is it possible that underlying the Fed’s preoccupation with inflation is really a concern about the dollar?

During the past year or so the relationship between the US dollar gold price and the US dollar exchange rate has become more widely accepted. Yes, I know that some people think the gold price is becoming disconnected from the US dollar but… it’s not. As more and more investors and, especially institutional investors, realize that they can play the dollar exchange rate by going long (or short) gold, the gold price becomes more volatile. The gold price may also from time to time move in patterns not predicted by the dollar exchange rate as investors establish (or dissolve) positions in anticipation of a move in the dollar exchange rate.

Take this past week as an example. The dollar rallied both in anticipation of a further increase in interest rates and in response to the German elections. But the gold price rallied alongside the dollar. Now, could it be that the gold price was rallying in anticipation of a decline in the dollar once the initial rally is over? Certainly if we look at Wednesday’s and Thursday’s activity it will confirm that the gold-dollar relationship is still intact. On Wednesday the dollar fell and gold rallied; on Thursday the dollar rallied and gold fell. Ditto on Friday. The question is, what happened prior to Wednesday.

One possibility is that long gold positions were being established in anticipation of a future decline in the dollar. Another is that short positions were being covered creating temporary demand. Either way, it seems to me that short term trading merely obscured the relationship between the US dollar gold price and the US dollar exchange rate that has by now been well established.

Paul van Eeden

Paul van Eeden works primarily to find investments for his own portfolio and shares his investment ideas with subscribers to his weekly investment publication. For more information please visit his website (www.paulvaneeden.com) or contact his publisher at (800) 528-0559 or (602) 252-4477.

Paul van Eeden works primarily to find investments for his own portfolio and shares his investment ideas with subscribers to his weekly investment publication. For more information please visit his website (www.paulvaneeden.com) or contact his publisher at (800) 528-0559 or (602) 252-4477.

Disclaimer

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