Collapsing Monetary Base Deflationary Threat to Gold

By: Ned_W_Schmidt

With $Gold now trading firmly above US$1,000, at least on a temporary basis, all are joyous that the Gold Bugs have won. The paper equity charlatans have been vanquished, at least for now. Those fanning emotions with stories about cabals, price suppression, and manipulation may now have to find some other drivel to pedal. GATA, the Gullible and Truly Amateurish, has now firmly been proven a purveyor of fantasy. Those that have opposed Gold and Silver ETFs can now, with knuckles dragging on the ground, return to the back of their caves

But yet, my mailbox continues to be filled with fictional stories such as those about OPEC abandoning the dollar. That happened despite the story being quashed by Reuters the same day it appeared. Is analysis of $Gold to continue as the equivalent of fantasy football? Or, shall we now move to a higher plain? Are we prepared, after an $800 GATA defying bull market, prepared to be rational investors? The spring has sprung. A goodly part of $Gold's under valuation has been corrected. Are we ready for analysis, or shall we continue to play "fantasy Gold?"

Our first chart this week is of Federal Reserve Bank Credit, the base fuel for U.S. money supply. The blue line, using the leftt axis, is the total of that monetary base, adjusted. Red line, using the right axis, is the year-to-year change in that monetary base.

In the past two months, far right portion of blue line, the Federal Reserve has added about $200 billion to the monetary base. That injection has been the fuel for the robust move in the paper equity markets and $Gold. For without that monetary fuel, markets would not advance. Forget discussions of fundamentals and earnings and deficits and products. Money is what moves markets.

While the blue line is encouraging, the red line is a giant red flag. The year-to-year change in the monetary base is collapsing. Regardless of the blather from the Federal Reserve leaders and economic gurus, Federal Reserve policy is already performing the equivalent of tightening. The second derivative of Federal Reserve Bank credit is decisively negative. In fact, Federal Reserve policy since February has contributed to the failure of the U.S. money supply to grow.

The failure of the supply of U.S. dollar to grow is attributable to the lack of demand for money, and an improperly designed monetary policy. Quite simply, the demand for, and perhaps the willingness to make, loans in the U.S. continues to fall. According to marketwatch.com's Rex Nutting(9 Oct), "U.S. banks are reducing their lending at the fastest rate on record, . . ." If loans are not made, the U.S. money supply will not grow without draconian monetization by Federal Reserve! If the money supply does not grow, the economy and financial markets will both weaken due to lack of fuel.

As a consequence of the lack of demand for loans, the unwillingness of banks to lend money, and subsequent response of U.S. monetary policy, effective U.S. monetary policy is one of tightening. That lack of growth in the U.S. money that followed from all this will ultimately have an impact on financial markets, the value of the U.S. dollar in the short-term, and the price of $Gold. Further, inflation is not likely to flow from this monetary policy, and deflation is again a risk. Importantly, the consequences of this situation may not be that of the broad consensus.

With no growth in the quantity of U.S. dollars since February, the dollar is becoming rarer relative to other currencies. Ultimately, unless corrected, the value of the U.S. dollar should rise in the short-term. Such an event might come as a surprise to those plunging into Gold and Silver on the back of margin debt.

Money is the fuel for markets, all of them. Money flowing into markets is the only way market prices rise. That is true for paper equities, Gold, Silver, and the price of land in North Dakota. Since the quantity of U.S. dollars in total is not rising, the only way for these markets to rise is by an increase in the share of the total money supply going into those markets or by market participants borrowing money. That latter act, of borrowing money, seems the primary fuel for paper equities, Gold, and Silver prices in recent times.

On one U.S. exchange alone, the December Gold contract is financed with roughly $12 billion of borrowed money, margin debt. Those are borrowings that require winnings, and losses cannot be tolerated. Any rally, even of a short-term nature, in the value of the U.S. dollar will send those borrowers of all those billions scurrying for the door.

Neither politicians nor central bankers are going to develop financial religion, and that is certainly true of the failing Obama Regime. Keynesianism continues to dominate both economic thinking and policy. No greater intellectual failure exists than Keynesianism, but it continues as the dominant economic ideology.

Keynesianism has demonstrated neither an ability to foresee the economic future nor the ability to serve as a tool for successfully managing the economy. Gold has served as a successful defender of wealth from the disastrous Keynesian policies of the past decade, and will continue to do so. However, do not let one be trampled by the momentum traders as they rush into the room.

By Ned W Schmidt CFA, CEBS

Copyright © 2009 Ned W. Schmidt - All Rights Reserved

GOLD THOUGHTS come from Ned W. Schmidt,CFA,CEBS, publisher of The Value View Gold Report , monthly, and Trading Thoughts , weekly. To receive copies of recent reports, go to http://home.att.net/~nwschmidt/Order_Gold_GETVVGR.html

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