The Fed Didn't Cause The Gold Bubble - Or Any Other Bubble

| About: SPDR Gold (GLD)

One of the persistent myths is that the Fed is the cause of the gold and other bubbles. Bubbles existed long before the Fed was even created. The first documented one, or at least the most commonly referenced one, is the great Dutch Tulip Bubble back in the 1600s. Bubbles are natural market phenomenon and in fact market bubbles are often replicated in finance classes. To address this we first have to define what a bubble is. This video does a good job outlining the characteristics of a bubble. Here are the relevant points:

1) Valuations deviate significantly from a long-term historical average

2) Analysts begin making outlandish predictions as assets hit new highs

3) Everyone and their mother is the new expert on investing in this asset class

4) People believe that "this time is different"

5) Political manipulation, unsustainable asset catalysts

Point 1: Reading the above list, it becomes obvious why the Fed is the unlikely cause of a bubble. Bubbles are focused on one portion of the economy like oil, then biotech, then dotcoms, then computer hardware, then real estate, then gold, then Apple (NASDAQ:AAPL), then Bitcoin and so on and so on. The Fed's monetary policy is a blanket, it isn't focused on one sector. The Fed's actions attempt to lift all boats, not pick and choose winners and lowers. Bubbles are when individual investors pick winners and lowers, and those decisions are made based upon expectation of future gains, not Fed monetary policy. Also, bubbles can occur during times of loose credit and tight credit. In fact, last time gold was forming a bubble was when interest rates were double digit. By the way, I'm pretty sure the Fed didn't have any Bitcoins on their balance sheet when it was forming its bubble.

Point #2: While the CPI is much maligned, there are plenty of market based estimates of inflation that simply show no inflation, or at least not at a worrisome level. Bond rates not only here in the US but globally are coming down, not up, as would be expected if inflation was driving prices higher. If we don't have high inflation, how can the Fed be blamed for causing bubble like returns? Almost every commodity is currently falling, and most are below their peak levels of 2008. Oil peaked out around $140/brl in 2008. It is hard to make a case for a "bubble" in commodities, when the major global commodity is trading 40% or more below its peak. My bet is that gold will soon trade near the late 2008 early 2009 level of $1,000. If it does, gold will be back to the exact level it traded at before all this money was printed out of thin air. If that happens it is game, set, match, checkmate for this theory. By the way, gold had a much bigger run prior to QE1 than it did afterward. Gold bottomed around $250 in 2001, and was trading near $1,000 in early 2008, a 400% increase. Since 2008, gold is up only 40%, and that is after QE1...QEn and near record buying of gold by central banks.

Point #3: Bubbles imply astronomical returns. The Dow Jones Industrials and and the S&P 500 are just getting back to where they were in 2008. Getting back to the starting point reached before all this money was printed out of thin air doesn't qualify as a bubble. Given that interest rates were much higher in 2008, on an interest rate adjusted valueation, we should be much higher than we are today.

Point #4: Printing money is not inflation, at least not price inflation. Inflation is usually defined as "too many dollars chasing too few goods." There is a dynamic where demand outpaces supply. Increased buying or a supply shock is necessary to drive inflation. Technically there is something called "monetary inflation" which is the printing of money. This definition of inflation is championed by the Austrian School of Economics, but this type of inflation is irrelevant to the markets. Price inflation is what matters to the markets, and price inflation is an aggregate increase in the price of goods and services. Yes they do remove "food and energy" from the "core" inflation number, but that isn't because of some conspiratorial cabal, it is because food and energy are extremely volatile because of market forces. Wars in the Middle-East will drive oil higher, droughts and ethanol policy will drive food price higher. Nothing monetary policy can do will impact wars, droughts and bad regulations, so they are removed from the equation. Food and energy are similar to what sunk costs are to an accountant. If you can't do anything about them, ignore them.

Point #5: Just because the Fed printed all this money out of thin air doesn't mean it goes into asset prices. Look at this graphic of the Fed's balance sheet. Clearly in late 2008 there is a huge expansion of the Fed's balance sheet. Assets go from about $900 billion to about $2 trillion in a blink of an eye. The chart shows assets growing to $2.5 trillion by the end of 2011. Currently the balance sheet is around $3.2 trillion. Using just this chart alone I'm pretty confident I could scare the living daylights out an unformed investor and get them to buy gold. If all you do is show someone this chart, claim that printing money causes inflation and tell them gold is an inflation hedge, then selling the gold story is easy. No one has had an incentive to say otherwise as long as people keep buying the lie, and gold keeps going higher. Critics like myself are easily dismissed when everyone is making easy money.

The problem is that there is an underlying inconvenient truth that everyone chooses to ignore when they are selling the gold story. There is an 800lb gorilla in the living room everyone has chosen to ignore. Yes the Fed's balance sheet did dramatically increase in late 2008, but so did excess reserves.

The Fed would basically print money, buy bonds from banks and the banks would deposit the newly printed money back into their regional Federal Reserve Bank. In one door, out another. From the above chart, excess reserves increased by $800 billion in late 2008. This chart proves that the monetary base increased by almost the exact amount as the excess reserves, increasing from about $900 billion to $1.8 Trillion, meaning that after printing $900 billion new dollars, only $100 billion actually made it into circulation. Not so frightening now is it? The problem is not frightening doesn't stick with the conventional wisdom about gold. Fear sells, calm doesn't. You don't see ads on cable TV telling everyone to calm down, everything is going to be alright. I can understand running these ads in 2008 when uncertainty was justified, but running them in 2013 requires ignoring a whole lot of facts, most important of which are that the claims made in 2008 never materialized. Sooner of later facts have to come into the thought process.

As this chart highlighting the fall in the velocity of money demonstrates, when money did make it into circulation, it wasn't spent as frequently . If the money wasn't sitting is some bank vault, it was hidden in someone's mattress, or stashed in a wallet, or worse, used to purchase gold that was then stashed in a basement. Key is, it most likely wasn't being spent on good and services driving up their prices...except maybe gold and Bitcoins.

What money wasn't being spent on gold and Bitcoins, was often spent paying off bills, not buying new goods and services. Consumers were deleveraging, which usually isn't associated with inflation and bubbles.

Lastly, while the monetary base increased dramatically, money supply did not increase nearly as much on a percentage basis. Where monetary base almost doubled from $900 billion to $1.7 trillion in late 2008, money supply only went from $1.4 to $1.6 trillion, and that was during a time of collapsing velocity of money, so MV=PQ would have been pointing to deflation, not inflation. Hardly the underpinning for an inflationary bubble.

Just for completeness, the money multiplier also collapsed in late 2008. From a monetary perspective, had people studied these charts back in 2008 they would have realized that the US and globe was facing deflation not inflation. I would still argue almost 5 years past that deflation is still a far greater threat than inflation. But once again, that argument doesn't sell.

In conclusion, what I tried to demonstrate in this article is that many of the arguments used to support the anti-Fed inflationary monetary basis for buying gold/SPDR Gold Trust (NYSEARCA:GLD) and blaming them for bubbles are simply unfounded. In my opinion fear was justified back in 2008, I would not have argued against people buying gold. At the time I had my theories like I outlined in this article, but no one knew for sure if the Fed would be able to pull off what they were attempting. I remember reading many articles during that time period and thinking to myself that "Ben Bernanke is following the text books." Each time there was a report I would think to myself "that is exactly what he is supposed to do, and had I been in his place I would have done the same." I've always believed that if you stick with the principles, ignore the politics and herd mentality of the markets things will eventually turn in your favor. That is what I believe is happening in the gold markets right now. Investors are finally seeing through the fear and looking at the facts and finally addressing the 800lb gorilla in the living room. Does my article mean we eventually won't have inflation? Absolutely not. That is the huge challenge the Fed faces. Yes the Fed has dramatically increased its balance sheet, yes all those excess reserves do represent a potential inflation problem in the future, but as this article written way back in 2010 proves, Ben Bernanke is well aware of that. If there is one thing the Fed is very very very good at, it is fighting inflation, and with near double digit unemployment, I'm pretty sure we are a long way off before inflation becomes the issue dominating the headlines. There are simply far to many real reasons and serious issues to worry about, and run away inflation isn't one of them. If inflation does eventually rear its ugly head, all one needs to do it review where all the above charts are, and watch over time how the Fed will alter them as they attempt to contain the inflation threat. That approach has kept me calm, focused and sleeping well since 2008.

Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.