GOLD & INFLATION - Chapter III
by
Eric Hommelberg
Last Update April 01, 2005
Gold & Inflation is chapter III of the Gold drivers 2005 report. It discusses the possibility of Inflation picking up steam and how it could affect Gold. Signs are surfacing everywhere that inflation is picking up steam indeed. the Producer Price Index remains avove the Consumer Price Index for over a year now which doesn't bode well for the CPI. Rising Oil prices are here to stay and will translate itself into a higher CPI. As long as the FED doesn’t raise interest rates fast enough in order to contain Inflation, real rates will stay negative. History suggests that negative real rates are on of the strongest drivers for the price of Gold.
This chapter will focus on :
-
1. Current Inflation numbers reliable ?
-
2. Future Inflation
-
3. Higher rates as a result of a dropping dollar good for Gold
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4. Negative real rates and Gold
1 - Current Inflation numbers reliable ?
Although official inflation statistics do suggest that inflation is well under control, the opposite seems to be true. Just ask people if they are happy with sky-rocketing food, energy and health care prices and you’ll get an idea. Hedonic adjusted Pentium IV processors won’t cure the pain felt in consumer pockets. Needless to say that over 90% of the American public don’t believe the official inflation statistics and neither does PIMCO’s managing director Bill Gross.
Bill Gross on adjusted inflation numbers :
“Talk about a con job ! The government says that if the quality of a product got better over the last 12 month that it didn’t really go up in price in fact it may have actually gone down! For instance, prices of desktop and notebook computers declined by 8% a year during past decade. The WSJ reports but because the machines computer power and memory have improved, their hedonically adjusted prices have dropped by 25% a year since 1997. No wonder the core is less than 2% with computers dropping that much every year.”
“Actually, to make the case for a government con job, it’s important to point out that the bulk of these hedonic adjustments have come only in the past few years, when it became necessary to buttress Greenspan’s concept of our New Age Economy.”
“Today no less than 46% of the weight of the US CPI comes from products subject to hedonic adjustments. PIMCO calculates that without them they would be between 0.5% and 1.1% higher each year since 1987.” END.
Ok you'll say, the government can mess up with so many goods by means of hedonic adjustments but what about oil and gasoline ? Higher oil/gasoline prices should be reflected in the government PPI/CPI numbers should't they ? Well, they don't ! The government just reports LOWER oil/gasoline prices instead of the real figures. You don't believe it ?
Bill King (from the King Report) reported in February this year :
The big rally in oil and gasoline is not reflected in the January PPI. BLS actually has energy prices down 1.3% for January, with crude energy prices down 4.5%! Absurd! The below charts show crude oil rallied from the low to high $40 handle; gasoline and heating oil surged while natural gas traded sideways. END.
The next day he continued :
We have been ridiculing the CPI for years. Yesterday’s CPI report is yet another bogus accounting of inflation. Energy prices fell 1.1% after falling 1.3% in December. Gasoline fell 2.1% and heating oil fell 5.2%. Gasoline prices are down 20.2% over the last 3 months annualized. Food & beverage prices fell 4.6% in the CPI-U (Urban) table while fuels fell 4.9%. Public transportation prices fell 0.8%. You saw the energy charts in yesterday’s missive. This is absurd.
Absurd indeed when the following Headline appears in the media :
US gasoline price breaks $2 a gallon, AAA says
the U.S. government projected that gasoline prices will hit a new record high this spring, reaching a national monthly average of $2.15 a gallon. END.
Well, they didn't have to wait for long :
Gasoline
prices hit nationwide record
Fri Mar 18, 6:13 AM ET
Gasoline hit a record nationwide average price of $2.055 a gallon, motorist club AAA reported Thursday, creeping up 0.2 of a cent overnight to eclipse the previous high of $2.054 last May. END.
So we have a government here
projecting record high gasoline prices although they are trending down according
to their own PPI/CPI statistics. To make things even more absurd just take a
look at the table shown below posted at LemetropoleCafe.com.
It displays the actual monthly average prices vs the Government reported prices.
Well, this table says it
all, the government doesn't report the real numbers but LOWER !
They do that in order to keep inflation rates low, it's as simple as that !
Conclusion : Inflation is actually higher than reported.
Another expert agreeing with this thesis is
professor Campbell
R. Harvey (Duke University)
Prof Campbell R. Harvey :
March 23, 2005
"I believe we have a more serious inflation problem than is widely acknowledged in the market," says Harvey.
The Producer Price Index (PPI), an indicator of wholesale prices, has been running above the Consumer Price Index (CPI) since March 2003.
"This is ominous," Harvey said. "On a year-over-year basis, the PPI exceeded the CPI in 2000, 1989, 1978 and the last half of 1972. When this happened over a sustained period, a recession has followed."
"The economic story is straightforward. The PPI is an advance indicator of consumer price inflation. It takes a while for the prices of production goods to work their way through the system and into consumer prices. The high PPI indicates substantially higher consumer price inflation in the future," Harvey said. END.
So we have higher Inflation than reported by government but for what reason inflation must reported lower than actual ?
Bill Gross :
“Alan Greenspan has a dual prerogative at the Federal Reserve. He is charged with keeping inflation low and economic output high. The magic of hedonic/substitution adjustments keeps both of these birds flyin’ at the same time, one under the magical 2% radar, which marks the dividing line between benign and worrisome inflation , and the other (real GDP), over the hurdle of 3% which suggest the continuation of high productivity. “
“My sense is that the CPI is really 1% higher than the official numbers and that GDP is 1% less. You’re witnessing a ‘haute con job’”. END.
Despite all the hedonic adjustments Inflation is getting noticed these days :
Manufacturers hike prices to offset commodity costs
NEW YORK, (Reuters) - Industrial manufacturers, who until recently footed the bill for high raw material costs, took advantage of surging demand to pass along the increase to their customers during the second quarter.
U.S. stocks to open lower as inflation data weighs
Tuesday November 16, 9:06 am ET
NEW YORK (CBS.MW) - U.S. stock futures are indicating a lower open Tuesday as broadly positive third quarter results from a slew of retailers including Wal-Mart and Home Depot, were offset by concern over a surge in October wholesale inflation to its fastest rate in 14 years.END.
CBS
MarketWatch
U.S. stocks open lower on inflation, oil jitters
Friday
December 10, 9:44 am ET
”NEW YORK (CBS.MW) -- U.S. stocks lost ground Friday as a sharper-than-expected rise in producer prices for November raised concern about a pick-up in inflation.”
“Within the report, core intermediate prices, a key leading indicator of inflation, has risen 8 percent in the last year, the worst inflation since 1981.” END.
Food Prices in
New York in Biggest Leap in 14 Years
January 20, 2005
Consumer Price Index for the New York region rose 3.8 percent as an overall average in 2004, the federal government said yesterday, as higher food prices and rising fuel costs drove the largest year-to-year increase in the index since 1990.
Energy costs in the region also increased last year - 14 percent over 2003 - but that was less than the 16.6 percent increase nationally. Rising gasoline prices continue to hurt the region; they rose 22.6 percent locally in 2004.END.
Inflation
is the main issue of uncertainty in the
U.S."
March 11, 2005
A major concern for Treasuries is "the weaker dollar and the
inflation piece of that story," said Ralph Axel, a U.S. government
debt strategist in New York at HSBC Securities USA Inc. "Inflation
is the main issue of uncertainty in the U.S.". END.
With Inflation picking up steam there is only one thing the FED can do and that’s to raise interest rates. According to Greenspan we shouldn’t be surprised to see the FED just doing that. On November 19 he said :
Greenspan, Nov 19 2004
"Rising interest rates have been advertised for so long and in so many places that anyone who has not appropriately hedged this position by now is obviously desirous of losing money.” END.
Indeed the FED is just doing that (raising rates) and made it clear (March 22) that it will continue to do so for the foreseeable future.
Conclusion : Inflation and higher rates simply can’t be ignored any longer.
A further enhancement to this conclusion is
given by the OIL/CPI graph. When CPI changes (Inflation Rate) compared to Oil you'll notice that higher
Oil prices never existed without high Inflation rates but now we're witnessing an
Inflation rate which is lagging the price of Oil tremendously. Higher Oil prices are
permanent due to increasing demand and flattening production curves so what
gives ? Oil prices coming down or Inflation rate catching up ? See graph below :
Stephen Leeb (president
of Leeb Capital Management and author of ‘ The
Oil Factor – Protect Yourself (AND PROFIT) from the coming Energy Crisis’.
said during an interview with Jim Puplava of Financial Sence Newshour :
Sharply rising energy prices, similar the the 70’s, will lead to double digit inflation figures over the next 10 years. It’s going to turn the economy on its head. END.
Chapter VIII Gold & Oil goes into detail why
oil prices will remain high coming years.
2 - Future Inflation
But what about coming years ? Maybe current Inflation issues are just temporary ?
Well, according to Peter Peterson and Laurence Kotlikof they are certainly not. Peter Peterson, secretary of commerce during the Nixon administration and Prof. Laurence Kotlikof, senior economist at the President’s Council of Economic Advisors (CEA) during the first Reagan administration, published excellent books lately ( “Running on Empty” , “the coming Generational Storm” ) in which they explain in greatest detail why the US is heading towards bankruptcy. They project a fiscal liability of more than 50$ trillion due to the baby boomer generation who starts to retire as from 2008. So a fiscal gap of $50 trillion+ is looming on the horizon but the sad truth is that this amount of money isn’t simply there. So how to solve such a fiscal gap ?
Kotlikof says :
“To close a $51 trillion fiscal gap, "you'd have to have an immediate and permanent 78 percent hike in the federal income tax."END.
Kotlikof refers to a pathbreaking study by Jagadeesh Gokhale of the Federal Reserve Bank of Cleveland and Kent Smetters, a former deputy assistant secretary of the Treasury Department (commissioned by former Treasury Secretary Paul O’Neill). They came up with a few very painful solutions on how to meet these liabilities :
More than double the payroll tax, immediately and forever, from 15.3 percent of wages to nearly 32 percent;
Raise income taxes by two-thirds, immediately and forever;
Cut Social Security and Medicare benefits by 45 percent, immediately and forever.
Eliminate forever all discretionary spending, which includes the military, homeland security, highways, courts, national parks, and most of what the federal government does outside of the transfer of payments to the elderly. END.
You don’t have to be a genius in order to understand that all of the items mentioned above is a one way ticket to political suicide so don’t count on them to be implemented.
Kotlikof conludes :
The country's absolutely broke,.This administration and previous administrations have set us up for a major financial crisis on the order of what Argentina experienced a couple of years ago." END.
But if this problem is so huge, why don’t we hear anything about it ? Why wasn’t it a hot issue during the presidential debates ?
Kotlikof :
Maybe the public doesn't want to hear it. Maybe politicians think ... the American public can't understand the truth or hear the truth or bear the truth. I think this is garbage. I think that people care about their kids and grandchildren and need to know the dangers facing them -- and us. END.
But what happened with the Gokhale report prepared for former Treasury Secretary Paul O’Neill ? Obviously Bush didn’t like it and O’Neill got fired. The $44 trillion fiscal gap report went into the dust bin. O’Neill after his resignation :
"It’s all about sound bites, deluding the people, pandering to the lowest common denominator," he said. "I didn’t adjust (in Washington) and I’m not going to start now."END.
Well, deluding the people, didn’t Bil Gross say something similar regarding reported CPI numbers ?
It should be obvious that the US government is literally drowning in its debt (see also chapter I Gold & US$) and this situation is getting more ugly year after year. But somehow this debt situation HAS to be solved, but how ?
Kotlikof comments :
The most common way to renege on official debt is to create inflation. For a quick tutorial in how to do it, just drop by heaven, purgatory, or an even deeper location that may be housing former president Nixon. Ask him to tell you how he reneged on official debt to pay for the Vietnam War. He’ll tell you that he sold bonds to the public to get the money to pay the military. Then he got his buddy Arthur Burns at the Federal reserve to print money to buy back the bonds. Sure enough inflation took off. Nominal interest rates, which are used to discount the interest and principal, shot up, and the real value of federal debt declined dramatically. END.
Does it sound familiar ? Deja Vu again ! Inflate your way out of debt.
Kotlikof concludes that in order to meet the fiscal liabilities exceeding $50 trillion you need a budgetary resource that only inflation can provide. According to Kotlikof the road to double digit Inflation numbers could be something like :
Any day now, bond traders, who, truth to be told, can be as tick as bricks, may start to react to our official deficit that is now almost running at 5% of GDP. Another flashpoint could be Alan Greenspan’s retirement. Greenspan has told the bond markets what to think for so long that it’s largely forgotten to think on its own. His exit could prompt a reappraisal of the financial and fiscal landscape. The sequence of events might run like this. Greenspan leaves. The dollar slides. Long-term interest rates rise. The Congressional Budget Office issues a warning about fiscal sustainability. The IMF comes out with a similar report. Long-term interest rates rise some more. Inflation picks up owing to higher import prices, which is due to the weaker dollar. Long term interest rates move into the double digit range. The stock market tanks. The federal reserve prints money to lower rates, but this raises Long-term rates even further. The economy moves into recession. Deficits hit 7% of GDP. Inflation hits double digits. The government cut taxes in a desperate attempt to stimulate economic activity. Japan and the EU look shaky. And we’re off to the races. END.
So several potential
flashpoints could trigger the whole thing. As Kotlikof points out bond traders
might react to the official US deficit exceeding 5% of GDP. Why this is such an
important threshold is described in detail in chapter I Gold & US$.
Bill Gross
points out :
“It’s another way of saying that U.S. yields depend upon the kindness of strangers and that the time to not own them is when the strangers become less kind. I suspect that is just around the corner but Beijing and Tokyo have the ball in their courts.”
“Wherever that should occur, there’s no doubt that the dollar is on the run and that higher U.S. interest rates are the inevitable consequence. Dollar depreciation leads to higher inflation and ultimately forces foreign creditors to question their rationale and indeed their sanity for continuing purchases of U.S. Treasuries. Investors don’t need necessarily “TOO MUCH” intelligence to do this trade.” END.
Well, as shown in chapter I Gold & US$, selling of US$ is already the tune of the day.
Kotlikof concludes :
The US is doing all the things that mark an economy soon to be wrecked by inflation and a weak currency.
- We’re running a large federal deficit, however it is calculated
- We’re cutting taxes so the deficit will be larger for a longer period of time
- We’re running a record trade deficit. It continuous to increase in spite of a weak economy
- We’re no longer a creditor nation. We owe billions around the world.
- Our government doesn’t seem to care
- We have implicit liabilities out the Gazoo
So what does Kotlikof suggests in order to protect investors against upcoming Inflation ?
Kotlikof :
Our response-and we’re serious- is to develop an interest in Gold and build an alternative portfolio that will provide some protection from inflation and a declining currency. END.
3 - Higher rates as a result of a dropping dollar good for Gold
As said before, if long term rates starts to rise and Inflation is picking up steam, the FED simply has to start raising interest rates. Indeed the FED started raising interest rates from a 40 year low of 1.0% but still has a long way to go to catch up with more realistic inflation figures. As Long as the FED stays behind the inflation curve real rates will stay negative which have been according to its own history one of the strongest drivers for Gold. The mainstream argument that rising rates are the death for Gold (a rate-hike should strengthen the dollar and therefore be bearish for Gold) is simply a lie. Rising rates as a result of a dropping dollar is very Gold friendly. What does history say about rising rates and Gold ? Well, you'll certainly remember the latest bull market in Gold from 1970 to 1980 right ? So what did interest rates do during that period ? Indeed they rose !
Yes, the 10 year yield
rose from a mere 5% from early seventies to an astronomical high of 15% in the
early eighties ! What did Gold do during this period ? It rose from $35 all
the way up to $850. From the early eighties till 2000 the 10 year yield came
down again from 15% to 5%. What did gold do during this period ? It came
down all the way from $850 to $255. Just look at the chart of 10 Y TSY and judge
yourself :
rising rates are the death for Gold is simply a lie
4 - Negative real rates and Gold
Don’t expect the FED to raise short term rates aggressively. The debt situation is too bad in order to absorb sharp increases of interest rates. Financial institutions like Fannie Mae and Freddie Mac won’t appreciate sharp rising interest rates. They are scared to death for sharp rising interest rates. And yes, a default of one of these giants can buckle the US$ !
Should we take this risk serious ? Well, earlier this year in just a matter of weeks, Greenspan, Snow and Fed governor Pool issued strong warnings regarding these financial giants, you really think this is without a reason ?
Fed governor Poole :
“While there is no crisis evident for the obligations of the housing government sponsored enterprises, their capital positions were "undesirably thin" and leave the firms "unnecessarily vulnerable to surprise shocks."
He said clear procedures for closing either company in a crisis should be established.
"Should a crisis occur, it will take hold so quickly that GSE obligations will in a matter of hours, or days, become illiquid. While any one holder of GSE debt can exit, not all holders can exit at once," END.
What kind of consequences a crisis at Fannie/Freddie could unfold according to Pool ?
"There is no question but that a crisis affecting either Fannie Mae or Freddie Mac would have widespread effects because these firms are so large," Poole said in remarks prepared for delivery to a banking conference organized by the Chicago Federal Reserve.” END.
So a crisis at Fannie/Freddie is certainly not an issue which will be celebrated by government. Is a crisis imminent at Fannie/Freddie ? Just repeat again the following :
"their capital positions were "undesirably thin" and leave the firms "unnecessarily vulnerable to surprise shocks.""END.
What surprise shocks you think he is referring to ? Well, my guess is sharply higher interest rates!
Alan Greenspan asked Congress again in February this year to curb Fannie/Freddie's growth. He said :
Going forward, enabling these institutions to increase in size, we are placing the total financial system of the future at substantial risk." However Al equivocated, "The risk now is, as best I can judge, virtually negligible. END
So with a FED not aggressively chasing higher interest rates leads to long lasting negative/low real rates. The inverse correlation between negative/low real interest rates and Gold is perfectly illustrated by the following graph created by Adam Hamilton of zealllc.com.
As Adam says this graph is a grand strategic chart, which vividly illustrates just how bullish for gold negative-real-rate environments truly are :
http://www.zealllc.com/2005/realgold8.htm
Indeed, this chart
doesn’t need any further explanation. Negative/Low real rates are powerful drivers
for the price of Gold, period !
Highlights :
- Inflation is picking up steam, consumers do notice already for a long time.
- Rising Oil prices are a significant contributor to higher Inflation
- CPI is lagging Oil tremendously today. History says that such an Extreme won’t stay there for a long period of time. Since Higher Oil prices are permanent, CPI will catch up.
- PPI continuously higher than CPI for almost two years now doesn’t bode well for the CPI. CPI will catch up.
- Future fiscal liabilities exceeding $50 trillion requires a budgetary resource which only inflation can provide.
- Government still insists that there is no Inflation, their statistics are getting comical.
-
Gold is the Ultimate Hedge against
Inflation
Future of US$ ?
Germany :
Inflation 1923-24:
A Woman feeds her tiled stove with money.
She chose to feed the stove with Money because
it cost less than buying the wood with Money.
- END -
