As a student (and teacher) of the Austrian School of economics, I despise the interventionist ways of the Federal Reserve. But as a gold investor, I appreciate the Federal Reserve’s “help” in boosting my portfolio. Like any prudent investor, I aim to buy low and sell high, and Fed policy right now can only lead the gold price in one direction: higher.
According to the Fed’s most-recent FOMC announcement, the Fed is looking to hold the federal funds rate near 0% for “at least through mid-2015,” which means that Operation Twist – the Fed’s program for selling its short-term government debt in order to buy more long-term government debt – is being extended for an additional year. On top of this, we have the organization’s new commitment to buying $40bn a month of mortgage-backed securities until such a time it deems this money printing unnecessary.
See the chart below.
The Federal Funds Rate is defined as “the interest rate at which depository institutions lend balances to each other overnight.” In other words, when one national bank is in need of more reserves (i.e., money) in order to maintain its reserve requirements, that bank can look to borrow money from another national bank that has more (or “excess”) reserves than is required. That bank then borrows from the other bank at the federal funds rate. (Note: the Discount Rate is the rate at which a national bank/institution borrows directly from the Federal Reserve.)
The rationale and hope behind manipulating the Federal Funds Rate from the Federal Reserve’s perspective is this: a lower rate will encourage banks to borrow funds from one another, which will then allow those borrowed funds to be lent out into the economy, which should then spur consumption and spending – boosting economic growth and the economy in general.
No such thing will occur, however, but the Federal Reserve can try as it may. What will occur is a strong price rise in gold, at least until 2015, and most likely beyond that as well.
If you look back at the chart above, you can see that the Federal Funds Rate jumped from approximately 5% in 1975 to over 18% in 1981. The reason this occurred was because, after being appointed in 1979, former Federal Reserve Chairman Paul Volcker pushed the rate to 20% by instructing the Federal Reserve Bank of New York to reduce its bank reserves, which in turn forced national banks to borrow less and interest rates to rise. In doing so, Chairman Volcker “saved” the dollar and annual inflation went from 12% in 1979 to 3% by 1983.
Intentionally or not, Chairman Volcker’s move also broke the back of the gold bull market and gold fell from a high of $850/oz in 1980 to almost $300/oz in 1982.
That is the power of the Federal Funds Rate: it has the ability to save the dollar and to kill gold. Simply put, it can be the gold investor’s best friend or worst enemy. From the gold investor’s perspective today, it is a toothless enemy and it need not be feared for a very long time to come. Here is why.
First, according to current Chairman Ben Bernanke, the Federal Reserve is targeting a “near zero” Federal Funds Rate for another two-and-a-half years until mid-2015. This means a looser monetary policy and, thus, money will pour into gold as a means to hedge against continuous depreciation of the greenback.
More importantly, even after 2015 comes and goes the Fed has no other option but to keep this rate at zero (or at least near zero) for at least two reasons:
One, if interest rates were to rise, the United States government – the biggest debtor in the world – would be completely unable to service the interest, let alone the principal, on its massive debt of over $16 trillion (a figure which doesn’t even begin to take account of future “unfunded liabilities” like social security, and the time-bomb that is state and municipal debt). See the chart below for what happened post-1979 to the interest rate on the 10-Year Treasury Note when Volcker started forcing the funds rate higher. Optimistic predictions are that debt interest will be costing American taxpayers close to a trillion dollars a year by the end of this decade. This makes it nigh on impossible for the Fed to “pull a Volcker” on the gold market without completely capsizing the federal budget.
The second reason is that if interest rates were to rise significantly, businesses and consumers will naturally start to borrow and spend less, which would then force businesses and entrepreneurs to either slow-down their operations or, unfortunately, cut-back on their work force. Simply put, high interest rates would turn into high unemployment. (See the chart below to see what happened between 1979 and 1981 when interest rates increased: 12% unemployment.)
Keeping these two things in mind – the amount of debt the US government holds and the precariousness of the unemployment rate – the only reasonable conclusion I can make is that the Federal Reserve must hold down the Federal Funds Rate at zero for a long time.
This means that gold is set to be strong for a long time as well. All thanks to Chairman Bernanke: a gold holder’s best friend.
Published by GoldMoneyCopyright © 2012. All rights reserved.