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Gold - Higher Price Already Baked Into The Inflationary Pie

Tuesday August 27, 2013 15:45

While there is a lot of chatter about tapering and the imminent demise of bonds, equities and gold there seems to be very little focus on how much money has already been created and the fact that will continue to grow, albeit at a slightly reduced, or tapered, rate. Perhaps the following chart puts monetary growth into perspective.

In 1998 the US monetary base stood at $0.5 trillion and the economy was chugging along at a nice, happy pace while the US Government ran a budget surplus. As Y2K approached the Fed ensured that there were sufficient funds available should bank computers crash etc. In the event not much happened and the money was drained from the system.

The recession followed and 9/11 triggered massive spending on the Afghan and Iraqi wars. By 2008 the monetary base had been expanded to $0.8 trillion up 60% in 10 years. Apart from the wars the major impact of the monetary expansion was price increases: housing, hard assets, oil, gold and other commodities as well as the bonuses of derivative traders.  

In the 5 years since the Lehman crash the US monetary base has increased 4.25 times from $0.8 trillion to $3.4 trillion. Since the halcyon days of 1998 the US monetary base has risen almost 7 fold from $0.5 trillion, with not much to show for it other than a US budget deficit of over a $1 trillion per year, a high level of structural unemployment, a much slower than average economic recovery and a general trepidation about tapering of the growth in the monetary base. Heaven only knows what markets will do if there were to be even a modest contraction of the monetary base let alone a reversion to the long-term exponential trend of $1.8 trillion.

In 1998 the Monetary Base stood at $0.5Trillion. It took 222 years to reach that level. In the next 10 years it grew by $0.3 trillion to reach $0.8Trillion in 2008. Post Lehman it has grown to $3.4 trillion with a $0.5 trillion jump in the last 6 months alone, as much as all of the paper US money that existed just 15 years ago.

This is extremely scary for as Milton Friedman said “Inflation is always and everywhere a monetary phenomenon”. However, it takes time to show up in what is laughingly referred to as CPI Inflation

Increasing the supply of a commodity, in this case US$ paper, will result in a decline in its price relative to other commodities. Measured against other currencies it is not falling because other countries have been printing just as much as the Fed. Notable of late has been Japan with the drop in the Yen vs. the US$ and on its way to 130 yen = $1 according to one Japanese official interviewed on BBC, to say nothing of the SA Rand and the Indian Rupee.

Think of the currencies jumping up and down on pogo sticks inside a room and there are cries of glee as one currency is up on the day and cries "Whee, I am stronger than you" etc., stand back a little and the room is in fact an elevator that is going down. Within the room there is no sensation of falling. Standing back a bit further and it can be seen that the elevator is on the Titanic.

Measured against the commodity gold, however, the US$ has certainly been debased. In 2000 an ounce of gold cost $252. How much gold can one buy today for $252? Answer, 18% of an ounce Alternatively the US$ has been debased by 82% against gold. So too has Sterling, the Yuan and many other currencies some more some less. Why? Because the total amount of above-ground gold has risen by only 1.3% pa as it has to be mined and cannot be printed. 

The full effect of the monetary explosion that is already in place has yet to be seen on the gold price and the price of many other hard assets, even equities for they are shares in income producing hard assets where the dividends are rising and are valued using the dividend discount model at levels much higher than their prices, e.g. the DJII value is 23,000 vs. its price of only 15,000.

The argument against this is that the 30 yr T Bond is artificially depressed by the Fed. However, the question this raises is "How on earth is the Fed going to be able to reverse the monetary expansion given the continuation of the huge US Budget deficit, most of it from interest payments and entitlements for years to come?" Particularly since foreigners do not want to hold US Bonds let alone buy any more.

The Fed has no choice but to continue monetary expansion until the economy recovers and takes over and beyond if the US budget deficit persists. By which time the inflation in money that is already in place will start to show up with a vengeance and taming it will be nigh impossible. 

What then does this mean for the price of gold?

As the US Monetary Base increases so too should the price of gold. Of late this has not been the case as hedge funds have been bailing out of ETFs and speculators have been shorting paper gold. Simultaneously the buying of physical gold from the East has exploded and inventories have shifted from West to East. This has historically never been reversed and there is no reason why it should be.

Looking at the relationship between US M1 and the gold price there has been a 0.96 correlation between the two as below:

Admittedly this has been with a lag. However, when the two diverge as they did in 2008 and over the past two years gold’s snap back up has been very rapid and tends to leave investors in the dust. It was the case with gold shares in 2008 and is likely to be the same now that gold has passed its nadir having been going in the wrong direction from its relationship with fiat paper. 

Massive inflation of money has already taken place. What is usually thought of as inflation, CPI, has yet to show up but it is on the way. Gold and all metals still have a long way to go and with them the shares of the companies that produce them as well as those which are exploring for them.

“How high is up?”

As a final terrifying thought, look at what printing money did to the Zimbabwe currency. In 1990 when I was last visited the country an ounce of gold sold at Zim$1,400 per ounce. After adjusting for the removal of all the zeros (except Mugabe) an ounce of gold just before the abandonment of the Zimbabwe dollar cost Zim$50,000,000,000,000,000,000 ($50 Quintillion?). Is this what we are facing?

Perhaps not yet, but starting with the price of gold at US$20 per ounce in the Nineteenth Century and adjusting for the 100 fold inflation since then it is easy to see gold trade well north of US$2,000 or even $3,000 per ounce and now is the time to buy while the gold speculators are calling for the demise of gold which over the millennia has proven time and time again to be a store of value or real money.

By Tony Hayes CFA
905 468 0130

Disclaimer: The views expressed in this article are those of the author and may not reflect those of Kitco Metals Inc. The author has made every effort to ensure accuracy of information provided; however, neither Kitco Metals Inc. nor the author can guarantee such accuracy. This article is strictly for informational purposes only. It is not a solicitation to make any exchange in precious metal products, commodities, securities or other financial instruments. Kitco Metals Inc. and the author of this article do not accept culpability for losses and/ or damages arising from the use of this publication.
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