Who Is Really Printing Money?

A popular mantra among many gold bugs is: “the Fed is printing money.” Any actions by the Fed to support liquidity in the markets are touted as “money creation” and consequently “monetary inflation” which causes gold appreciation. If gold does not rise, they proclaim that there is “manipulation” and “conspiracy”.

It is fair to say that we do not see the picture in such black and white colors.

The main source of new money in the economy is not the Fed but the commercial banks. It is the private banks that increase money supply through debt (new credit) creation.

During a credit crisis which is characterized by a steep slowdown of credit creation, growth of money supply in the financial system slows as well. It is silly to think that the Fed can replace the whole system of commercial banks by creating money itself from thin air. What the Fed can do is influence money supply by adjusting interest rates, creating more or less incentive for the fractional-reserve lending by the commercial banks.

Lately, the Fed has expanded its sphere of influence but these actions still do not directly cause increases in money supply. The Fed began swapping poor performing assets on the banks’ balance sheets for the high quality treasuries on the Fed’s balance sheet in an effort to improve the financial situation of the banking sector and restore liquidity.

Today, the biggest fear that the Fed has is the fear of deflation. The monetary policymakers understand that (a) a sound banking system is a foundation of US economic prosperity and (b) the failure to support the banking system will inevitably cause deflation. We are, therefore, confident that the Fed, headed by Chairman B. Bernanke, will continue to support the banks by creating the best possible environment for the return to a normal cycle of debt/money creation and use everything in its arsenal to prevent deflation.

Going forward, gold will likely resume its up-trend due to one of two reasons:

1. Another spell of problems in the financial system will cause gold (and the US treasuries) to once again take the place of safe haven investments, as was the case in the second half of 2007.
2. Fear of deflation and a further slowdown in the US will spread around the world. As a result, a vicious wave of competitive devaluation will cause not only price shocks (oil, food, etc.) but also spiraling monetary inflation, eventually raising long-term bond yields. This will be the beginning of a real gold bull market when gold outperforms all other major classes of assets including most hard assets.

The second outcome, in our opinion, is inevitable but no one knows when it will come and what path it will take.

Gold Price Action

In the middle of July, gold touched its upper Bollinger Band (see weekly chart below). At that time a large wave of profit-taking and commodity liquidation began, causing gold to plunge by over $100/oz.

Gold held its May low of $946, which was critically important for the near term. Most technical analysts now see this support will eventually be breached and gold will touch its 65-week moving average in the low $800s.

Unfortunately, this outcome is now quite likely, meaning that the duration of the correction could be extended by an unknown length of time, from a couple of months to as long as a year.

One outcome that we feel we have to mention is the worst case scenario. The current commodity correction could extend for a few more months, easily pulling gold to below $800. If gold stabilizes in the $700s, lower $800s would become new resistance levels, causing precious metals to stall for a longer period of time.

Although this will in no way cancel the secular gold bull market, it will, however, likely lead to a cyclical bear market. The chart below shows that gold can fall to the lower $600s and still keep the long-run gold bull alive. During the seventies’ bull market gold lost about half of its value in a period of two years, just before embarking on an unprecedented run that took the price to $850/oz.

One more point. Gold ended 2007 at $838 per ounce. Is it so outrageous to expect 2008 to be a down year for gold, after seven straight years of gains? We think not.

While this bearish outcome for gold is not unreasonable, how would gold stocks react in this scenario? This is an excerpt from the Resource Stock Guide Newsletter dated August 10, 2008.

Comments

[buyitcheap:]

given that production costs seem to be averaging over $500 an ounce,a pull back to $750 would be a great buy.

2008 Aug 11 09:51 AM

[Thunderlight:]

Great article.
I remember Jim Rogers once said he'd be buying gold if it dips to 750.

2008 Aug 11 10:33 AM

[JBP:]

Jim Rogers, Stephen Leeb, Ken Heebner, and Buffett are all betting against the dollar and the first three are huge commodity bulls. Rogers and Leeb both have made predictions of $2000+ gold in the next 5 years. My money is with them....

2008 Aug 11 11:06 AM

[JasonC:]

The chart simply shows the left half of a classic head and shoulders top. Gold will retreat to the $600 level and then move sideways in a trading range between $600 and $700, for a prolonged period. This move will not be instant, an diehard commodity bulls will resist it the whole way. But it will happen.

The necessary underpining for the bulls narrative fantasy is reckless monetary expansion by the Fed. There hasn't been any reckless monetary expansion by the Fed in over 3 years. M1 stopped moving in March of 2005, as the Fed tightened to break the real estate bubble. It has not allowed reserves to increase since then. All of its more accomodative moves since last summer's interest rate peak and crisis have been offset, dollar for dollar, by selling treasuries in the open market.

The commodity bubble is not based on realities but on an ideological narrative line. It will evaporate as all bubbles do, leaving chaos in its wake.

Banks will repair their balance sheets gradually over 2-3 years. Present low rates on the short end are not excessively stimulative because almost no one actually has access to them. Spreads remain very wide, with 6% normal for mortgages and high quality intermediate term corporates. Finance names and real estate names are paying 9% on preferreds, and still have more capital to raise at such rates. Debt liquidation continues at high rates.

These are not circumstances you can spin into a hyperinflation.

2008 Aug 11 01:01 PM

[GaryD:]

Yup. The fed seems to have escaped the banking crisis without inflating the money supply. Indian demand is also way down (56% yoy). This has resulted in very low (or even negative) gold lease rates. All of this is bearish for gold. My guess is that gold is done for a while.

2008 Aug 11 01:07 PM

[User 86945:]

JasonC,

Could you be so kind as to suggest some of these preferred names with double digit yields?

2008 Aug 11 06:00 PM

[bearfund:]

I'm happy to buy a little at today's price. I'd be even happier to buy more at 730. Your long-term trend line is at 600 - that would make me giddy as a schoolgirl. If the Fed isn't happy with the pace of money creation, they'll find ways to make even more. They are determined to "reflate" (i.e., blow more bubbles) and where there's a will, there's a way!

2008 Aug 12 02:04 AM

[Russ Osborn:]

Also, don't forget that the US federal government is financing budget deficits by burdening Social Security and federal employee pension plans with additional debt, meaning that (assuming these programs remain in place) the fed will eventually have to print money proper. Add to that a $3 trillion war (per Stiglitz & Bilmes) and money will be rolling out like toilet paper.

2008 Aug 12 02:55 AM

[Jimbo:]

I have to support Russ Osborn. I see the economy poised on a knife edge. Tip one way and you are in deflation. Tip another way and you have inflation. The enormous overhang of unfunded debt, mentioned by Russ, seems to me to mitigate for eventual inflation. I don't see "Mr. Market" as having a personality, but comments about the market trying to shake off weak hands seems very credible. I am quietly sticking with a modest accumulation of precious metals in funds and mining companies. Patience will be eventually rewarded.

2008 Aug 12 12:06 PM

[CaptBob:]

The department of the Treasury does the actual printing of the notes for circulation by the Federal Reserve.
That is where the Commercial banks "borrow" it from, currently at 2% interest. They do NOT create it.

Quote--top of Aticle>
"The main source of new money in the economy is not the Fed but the commercial banks. It is the private banks that increase money supply through debt (new credit) creation." Technically true but somewhat misleading.

There are other means the Fed and other Central Banks have of placing fiat currency in circulation, which is why the deficits and surpluses of the Nations of the world do not balance---by a wide margin!. These figures are not released to the public and are one means by which the values of different currencies are manipulated versus each other. Always to the detriment of the citizens whose holdings have been devalued--another form of taxation!!

2008 Aug 12 12:07 PM

[Charles Lon...:]

Good insights in this article. A pause in gold's recent climb had a single prophet voice last month, and that was Elliott Wave International. At the time it made no sense. The 600 number also shows up in their analysis.

2008 Aug 12 12:56 PM

[Francis Sch...:]

Elliott Waves and gold: There are different ways in numbering the gold chart. Making a mistake can put one on the wrong side of the market for some time. Accoding to my numbering, we still are now having an ABC correction prior to leg 5 which should last all the way into the beginning of 2009. Additionally, an inflation adjusted price of $ 600 for Gold just doesn't make any sence as the Real Interest Rates are negative and the monetary inflation keeps on rising by almost 20 % annually.

2008 Aug 12 05:20 PM

[akur01:]

Boris. Have you not seen graphs of US money supply lately? Money supply is growing parabolically. The US Fed "officially" stopped publishing money supply numbers. Hmm...I wonder why? Could it be that they are trying to hide the fact that they are printing money like bandits?

"High quality Treasuries" The US Fed has had bond offerings recently that went unfilled. What will things look like when foreigners stop supporting US debt, as they have already started to do? The monstrous liabilities and debt the US has will have generational effects going forward.

"A sound banking system" The banking system's knees are buckling under huge leverage, and the "foundation" of the US Fed is starting to crack.

I feel for our children and grandchildren, that will bear the tax burden of terrible US financial policies.

The US Fed is headed for insolvency. It's a shame.

2008 Aug 15 11:59 AM