Fed Rate Cuts Backfire, Lift Gold and Oil into Orbit

"Too Much Money Chasing Too Few Commodities" might be the best way to explain the historic rally that has lifted the Dow Jones AIG Commodity Index into the stratosphere. Central bankers in 18 of the top-20 economies in the world have been expanding their money supplies at double digit rates for the past several years, trying to prevent their currencies from rising too quickly against the terminally ill US dollar.

In response, fund managers have turned to commodities, as a hedge against the explosive growth of the world’s money supply, competitive currency devaluations, escalating inflation, and the negative interest rates engineered by central banks. To the chagrin of central bankers, much of explosive money supply growth is flowing into the commodities markets, and elevating inflation rates to multi-decade highs.

The Federal Reserve is the chief culprit behind the explosion in global commodity prices, slashing its federal funds rate at a frenzied pace, to arrest a year long slide in US home prices, which, if left unchecked, threatens to topple the US economy into a severe recession. Nearly 8.8 million US homeowners hold mortgages that are larger than the value of their homes, providing an incentive to abandon houses bought on speculation. And, according to the Mortgage Bankers Association, the delinquency rate for 3.6 million sub-prime mortgage loans was 17.3% in the fourth quarter.

Wall Street is worried that foreclosures and delinquencies will escalate when many sub-prime loans face built-in interest rate resets that could lift borrowing rates as much as 3% higher in coming months. The worst payment problems have been among sub-prime adjustable-rate mortgages, and more than one-fifth of these outstanding loans were seriously delinquent at the end of 2007.

But as the Bernanke Fed slashes interest rates to stop a slide in the US housing and stock markets, and expands the MZM money supply, at a hyper-inflation rate of +15.7%, it’s also simultaneously blowing enormous bubbles in the precious metals and commodities markets. The surge in agricultural and energy prices have led to a +7.5% jump in US producer prices, the biggest 12-month gain in 27-years, and consumer prices are up +4.3%, a 17-year high.

However, “In my view, the adverse dynamics of the financial markets and the economy present the greater threat to economic welfare in the United States. Policy-makers must take into account the possibility of very unfavorable developments,” said Fed deputy Donald Kohn on Feb 26^th. “We have the tools. As Chairman Bernanke often emphasizes, we will do what is needed!!” Kohn warned.

Such tools include driving the federal funds rate to zero percent if necessary, pumping the MZM money supply growth to above 20%, or buying long dated Treasury securities with printed money. So far, the Bernanke Fed’s aggressive rate cuts have done more harm than good for the US economy, leaving the US consumer with slumping home prices on the one hand, and soaring food and energy prices on the other hand, caught in the “Stagflation” trap.

Such reckless policies could also unleash hyper-inflation in the US economy, and trigger capital flight from the US dollar. On Dec 27, China’s powerful FX chief, Hu Xiaolin warned, “If the US federal funds rate continues to fall, this will certainly have a harmful effect on the US dollar exchange rate and the international currency system." China’s foreign exchange reserves jumped $61.6 billion in January to reach $1.59 trillion in January, after growing $462 billion last year.

Yet even with crude oil closing at a record high of $104.50 /barrel on March 5^th, and gold trading near $1,000 /oz, Cleveland Fed chief, Sandra Pianalto, said the Fed should continue to err on the side of easing. “Because credit contractions can emerge and spread rather quickly, the central bank must be prepared to act in an aggressive and timely manner to counteract their effects,” she explained. The Fed has room to maneuver, because, “Inflation expectations appear to be anchored,” she added.

Foreign Central Banks Decline to Follow the Fed

However, most other central bankers are not willing to follow the Fed’s strategy of hyper-inflating the money supply, despite the extraordinary risks associated with deteriorating credit conditions in the global banking system. Banks and brokers world-wide could recognize more than $500 billion in losses from toxic sub-prime US mortgage debt in the year ahead, blowing big craters into their balance sheets, that won’t be plugged by sovereign wealth funds from the Middle East and Asia.

Yet central banks from Brazil, the Euro zone, England, Korea, Japan, and New Zealand left their lending rates unchanged this week, while the Australian central bank hiked its cash rate a quarter-point to 7.25%, a 12-year high. The People’s Bank of China drained a net 226 billion yuan ($32 billion) from the Shanghai money markets this week, after it drained a net 164 billion yuan ($23 billion) last week.

Yesterday, the Euro soared to a new all-time high of $1.5370, as interest rate differentials continue to move in the Euro’s favor over the terminally ill US-dollar. Tough anti-inflation rhetoric from European Central Bank chief Jean “Tricky” Trichet snuffed out expectations for a Euro zone rate cut anytime soon. “The ECB is strongly committed to preventing second round effects and the materialization of upside risks to price stability over the medium term,” Trichet declared.

Apparently, the ECB is guiding the Euro higher to help offset some of the surge in energy and food price-fuelled inflation, despite the potential hit to Euro zone exports. Contrast that with the Fed, which has already slashed rates 225 basis points and is constantly trying to brainwash the American public and global traders into believing the fairy tale that “Inflation expectations are well anchored.”

As the marketplace continues to lose faith in the Fed’s anti-inflation credibility, it will complicate the central bank’s ability to put a safety net under the stock market. “Any tendency of inflation expectations to become unhinged, or the Fed’s inflation-fighting credibility to be eroded could greatly complicate the flexibility of the Fed to counter shortfalls of growth in the future,” Bernanke admitted on Feb 28^th.

In a world of fiat (paper) currency, the full faith and trust in a nation’s currency often lies in the policy actions and honesty of its central bankers. Under the Bernanke Fed, global confidence in the US dollar is being torn apart, and the Fed rookies hand picked by Mr Bush, are not telling the public the truth about the inflationary consequences of their actions. The Bernanke Fed is playing Russian roulette with the greenback, and a speculative run on the dollar is now in motion. Yet the Fed’s propaganda machine remains defiant, “I don’t think that foreign investors have lost confidence in the United States by any means,” Bernanke told the Senate on Feb 28^th.

Fed Rate Cuts Lift Crude Oil Above $100 /Barrel

Expectations of a 0.50% Fed rate cut to 2.50% on March 18^th has already greased the skids under the US dollar, and convinced speculators to bid crude oil to $105 /barrel. The OPEC-10 cartel wants to be compensated for a weaker US$ with higher oil prices, and held its oil output quotas steady at 27.2 million bpd, insisting oil markets are well supplied and blamed record prices on factors outside its control.

OPEC chief Chakib Khelil said the Federal Reserve, not OPEC, is to blame for high prices. “The US slowdown and lower interest rates have lowered the value of the dollar, and encouraged speculative flows into oil and other dollar-denominated commodities. What’s happening in the oil market is due to the mismanagement of the US economy, which is affecting the rest of the world,” Khelil told a news conference.

Saudi oil chief Ali al-Naimi noted on March 4^th the growing influence of financial traders who have ploughed $200 billion into oil and commodity markets as a hedge against inflation and the weakening US dollar. “The current oil price has no relation to market fundamentals. It is linked to oil futures, which are witnessing tremendous speculation. There are even those who buy futures and speculate that oil prices will reach more than $200 in 2013,” he told the London-based daily al-Hayat.

Right now, futures traders are debating whether the Fed will slash the fed funds rate by a half-point or 0.75% on March 18^th, but in either case, the US$ index could be stripped of its life support, and left sliding into a bottomless pit, which in turn, could lift crude oil higher in the weeks ahead. Worse yet, the US economy imported $330 billion of oil from abroad last year at an average price of $64 /barrel. If the US is forced to pay an average $100 /barrel this year, it could boost the import bill by $175 billion, and completely wipe out Washington’s $152 economic stimulus package.

Gold set a historic high near $1,000 an ounce and silver jumped to a 27-year peak, as a record low dollar and soaring oil triggered a fresh wave of bullion buying. Spot gold rose as high as $991.80 an ounce before slipping to a low of $960 /oz. Europe’s wealthiest families are planning to shift more of their investments further away from stocks and bonds and into alternatives such as hedge funds and commodities.

While gold’s spectacular rally against the pathetic US dollar usually gets most of the world’s attention, the yellow metal has also soared by 20% against the Euro, from four months ago. The Euro M3 money supply is expanding at a +11.5% annual rate, or three times faster than the ECB’s original target, which was deemed consistent with low inflation. The ECB hasn’t met its 2% inflation target for the past six years, and inflation is now 3.2% higher from a year ago, a 16-year high, according to calculations that have been heavily doctored by apparatchniks at Eurostat.

But gold’s rally against the Euro has become more restrained, as Euro Libor futures contracts begin to slide in Frankfurt, and wipe out any hope of an ECB rate cut for the first half of 2008. On Feb 14^th, Bundesbank chief Axel Weber warned, “current interest rate expectations on financial markets do not reflect an appropriate assessment of the inflation risks, at least for a stability-oriented central banker.”

For now, the ECB wants to see if a steady repo rate at 4% can block gold’s advance at 650 euros /oz. But with the Fed determined to slash its federal funds rate in the months ahead, regardless of the inflationary consequences, and other foreign central bankers unwilling to tag along, the stage is set for extreme volatility in exchange rates, which in turn, can trigger wild gyrations in the commodities markets.

Comments

[nScout]

Right on! That's the end you get when waging a trillion $ half-war, caving in to banks and altogether losing all sense of leading a country.

[mongoose]

It appears that you guy's have it nailed. Maybe it's time for an Independent to be considered.

[sdavid0419]

I agree with most of the above. As to TonyC's indication of baby boomers retiring I would like to add some points of view. I think his 1/3 takers will not be that high with runaway inflation an early retirement is tough to make work. Also, thanks to Clinton the way the government calculates inflation for Social Security COLA's is 1/3 or actual inflation thus burning the old folks who need this fixed income to live on. I believe the current economic policy is the final leg of the conspiracy to disolve the sovereignity of the United States and form the North American Union on way to the One World Government. Lay offs have just begun and already we have teachers and air traffic controlers arguing for raises to help offset this rediculous inflation. The next phase will be extended stagflation with demand to extend unemployment benefits. The way I see it either Clinton or McCain will continue the march towards the one world goal. I believe they are covering their bases by goading O'bama into takin Clinton as a VP as an insurance policy. I truly believe if he takes Clinton as his VP he will be signing his own death warrant.

[pharma]

Unfortunately, democrats do not offer any alternatives.

The entire US economic model is a joke. "Consumer society" is nothing more than a fraud. One can only wonder how it could last for so long.

It is obvious that Bush administration and Feds would like to move the problem [a deep recession or a depression] past this year election. But being so incompetent, their chances are zero. Only one area where they will succeed beyond their imagination is ruining US economy.

[oldgoldbug]

Why is the long bond market so sanguine about all of this? Are they wrong? Are they thinking major recession? If so, can the commodities keep going?

[eric hart]

The bond market is wrong because the bonds aren't being bought just by rational investors, they are also bought by foreign governments to recycle dollars.

Yes, commodities can keep going because 1) the alternatives are worse, and 2) there is an excess of capital looking for a home in an increasingly inflationary environment.

[permionix]

OK, i'm a dolt. What is the definition of MZM as in US MZM money supply? One of the numbers from one of the "colored" books?

[TonyC-SA]

pharma: No, democrats don't offer much. The only thing that can save us is getting off of Middle-Eastern oil; which means reducing our oil consumption about 45%. (A good portion of our oil comes from Canada and South America).

The only plausible method I know of doing that domestically is not solar, wind, biofuel, coal, nuclear or hydro. Those things have their places and their problems; such as exotic materials, intermittency, lack of infrastructure and pollution and environmental impact and waste problems. The answer is simply geothermal.

It is green, emissions free, environmentally neutral with a tiny plant footprint, requiring zero fuel delivery, available throughout the USA (at different depths), tested for decades, cheap to build requiring zero advanced technology and consisting of primarily steel and copper, and if terrorists attacked it they would just disrupt one plant on a grid and mess up a hole in the ground. On top of all that, MIT estimates (2007) indicate that with a little research we can produce geothermal electricity at a break-even of about half of current retail costs, and our untapped geothermal assets are capable of producing 2000 times the entire USA energy budget annually, and they never run out. If you like hydrogen fuel cells to replace gasoline, the geothermal electricity can be used to do the splitting. It can also be used to desalinate sea water, and pump the fresh water anywhere we want it.

Of course no candidate is talking about it, because it isn't sexy and doesn't fit into the current subsidy structure, and coal fired and gas fired CO2 spewing plants aren't easily retro-fitted, and those coal miners and oil barons wouldn't be happy if we made them obsolete, and those farmers counting on producing even more CO2 generating biofuels don't want to give up their subsidies.

Geothermal is the only viable solution. Plants can be built in parallel in practically every county in the country and operational within 6 months, they can even be located in the heart of cities. One thing oil HAS taught us is how to drill ANYWHERE.

And like I said, we don't need full energy independence, or even independence from all oil. Just the 45% that creates the threats we face to security and blackmail. But whatever, we will probably just keep pretending to address the problem by building windmills that can't generate more than 5% of what we need, and talking about solar that can't generate more than 5% either (and much of which cannot be built because the world supply of the exotic metals needed doesn't exist), or keep talking about biofuels that we cannot even prove break even and steal farmland and create CO2 concerns just as bad as burning coal. I suppose it will take an energy depression to make us actually look at the problem like adults.

[AWi]

Tony C, you are 100% correct in your comment about geo-thermal energy, and your additional comment on solar and wind. Spread the word, it will eventually get out to the masses. When it does, OPEC will get very nervous, oil prices will sink like an anchor if the entire world gets on the geo-thermal band wagon.

[smart money]

The Fed is going to cut rates atleast .50 % . The best thing to do in the short term is to buy gold.
Gold is so cheap compared to what it cost in the 70's. We will see $2500.00 Gold or higher. It is and has always been the hedge against inflation and a falling dollar.
We will most likely see the same thing happen in all commodities and worst of all oil. It 's not bad enough that we are facing supply shortages that are only growing , but now we are seeing hedge driven invesments to offset rapidly growing inflation. Inflation I believe will be above 15% in the next two years. Make your money now in precious metals, oil services companies and drillers. I also like alternative energies, we will see growth of a 1000% in the next 5-10 years. Look to the large industrial solar companies that are finding ways to reduce solar costs. Coal would be a good economy booster for us also. We have alot of it and in the near term and it would quickly reduce the cost of oil. Coal liquidfication is a rapidly growing industry and it burns as clean as gasoline. The US has had this technology for years. It would also create alot of jobs right here at home and all the tax cuts that go to big oil, could go to alternative energy, no matter what kind of alternative energy we use.
Our worst enemies are( Middle East) becoming in control of our economic growth and futures. This war is becoming the war of the have's and have nots, and we have not any oil!

[poet1]

Today ( March 7 )the fed/Bush said that they are raising the dollar amount that the fed can lend to banks, approx 50(?) billion. What effect will this have?

[maxbid]

Tony C, your comments on geothermal are spot on.
However, your comment about solar is wrong: "and talking about solar that can't generate more than 5% either (and much of which cannot be built because the world supply of the exotic metals needed doesn't exist)" is not correct. Sand is the basis for mono and poly silicon. Sand is plentiful. And China is aiming at solar to provide 20% of it's electric needs by 2020. Why can't the US do the same?

[jjason]

I disagree about owning gold. Yes it does go up but only because people push up the price. Like anything that is in short supply, if people bid up the price, the price will go up. I have heard people say that over 150 years, if you held gold, the compounded annual rate of return would have been 5%. As a retired baby boomer, I look for DIVIDENDS and short term capital gains. I have not seen anyone paying a dividend on gold. Also, gold mining stocks do not pay dividends worth a dam. So keep buying gold...it is a zero sum zero game because the price of gold goes up and down too. Finally, if people would say "I'm not paying $900.00 an ounce for that stuff" and stopped buying gold, watch how fast the price would drop. I wouldn't pay $100.00 an ounce for that stuff. I don't even own any gold jewelery. Gold has no value to me at all.

[scriblrr]

Fascinating discussion.
I do love geothermal, and I am a great believer in solar power. But, these are long-lead changeovers. I don't think you've given enough consideration to liquified coal with C02 sequestration. This process creates a clean fuel for new, low-emission diesel engines (now available in Germany). It's way-cheaper to produce than gasoline, right at the mine, requires no catalytic cracking refineries, can be distributed by pipeline, and will fit into the existing "gas station" distribution scheme. We have an enormous, humongous supply of coal, right here in North America. Want to make the Saudis quiver? Just announce a government aid program to Americans and Canadians who will buy a new-design diesel equipped to run on liquified coal from HERE! Yes, there will be a transition, but the longer we waste our time and money operating vehicles powered by inefficient, costly, four-cycle internal combustion Otto engines, the longer we will be economically enslaved to potentates who despise us.

A company that is deep into liquified coal is Headwaters (HO). Cjeck it out!

[User 161954]

Ron Paul was written all over this article. A world conciousness must arise and see central bankers for what they really are. The Founding fathers warned about this. Article 1 section 10 of The Constitution states that only gold and silver can be used in the coining of money. NEVER has a Paper money endured. A system designed for the profits of the few at the expence of the many truely denies freedom.

[maven12]

Lots to chew on; but let's get some balance:
1. Do not look to politics for a quick solution. Neither Democrats nor Republicans can stray to far from the middle.
2. Do not look to interest rates or Fed intervention for a quick solution. Our credit mechanisms and the inherent trust involved have been damaged severely.
3. Energy use and production is one place we can restore the US's economic leadership. Conservation first, of course; but then alternative energy. Solar, wind, geothermal are ALL needed, not just one. Imagine what reducing the importation of oil and natural gas can do for our economy! (Intermitency in alternative energy isn't a problem if you have a balanced system...) By the way, solar is not only photo-voltaic, but includes concentrated solar plants which use no silicon at all; but giant collectors.
4. We've pretty much used all the "low cost" resources -- air, water, other people's labor, etc. Now we need to make changes to use what we have responsibly.

[Kman]

Very enjoyable article, as well as all the comments. One question tho, what about the dangers of drilling deep into the Earth's core for Geothermal energy? Could this set off an expansion of unexpected pressure causing shifting of the mantle plates resulting in increased "earthquakes"... or worse...magma flows? Anyone?

[sricheruvu]

obviously the US Fed is undermining the credibility of the dollar. However since there is no other currency for global transactions to replace the US Dollar yet, I could see the uncertenity of this situation causing considerable gyrations in the global markets.

[Cygnusx3]

To what extent do you believe that gold has priced in this situation already? (As dire as it is)

[cheesecake]

overall i enjoyed reading your article and agree with most of it, although you are a little too doom and gloom for me.
secondly, people are posting ludicrously stupid comments, as opposed to 2 weeks ago :)

[RichardSchweitzer]

Let us paint a drastic scenario:

Let's assume that "China" decides to convert its "reserves" that are in U. S. dollars into petroleum reserves by "discounting"... the U.S. $$ to offering $1,080 per barrel, and storing oil on the mainland. Then continuing to convert $$ reserves, discounted, into (mostly oil), but into iron ore, coal, copper and refined steel goods (chrome. etc.).

And, in defense, would Japan not have to follow, at least on oil?
Prudence would call for some actions in that direction.

[hogi]

tonyc, I agree with you- geothermal is the way to go. Do you know of any geothermal energy research or resources?