March 11, 2011
 

There is heated debate going on between those who believe the Fed is creating huge amounts of money that will inevitably lead to soaring inflation, and those who don't.  What makes this debate singularly important -- and interesting -- is it is a debate between free market advocates, all who believe an artificial increase in money and credit, is inflationary.

 

The essence of the argument is not whether the Fed is creating new money. All agree on this point, including the Fed.  The debate is whether that money will lead to substantially higher prices.  Some argue it is doing exactly that today -- after all, look at gasoline prices.

 

A lot depends on one's vantage point.  The average person lives in an anecdotal world where what he sees and buys is how he determines the degree of inflation. If gas and food prices are going up, we have inflation. Economists on the other hand, live in a statistical world in which they compare indexes of large groups of prices of goods and services throughout the nation.  One does not approximate the other.  The individual sees his prices going up at the local gas pump and grocery store, while the economist is looking at across the board increases in prices nationwide.  The first group sees prices rising by 10 and even 20%.  The second group sees rises of only 1 to 2%.  Both are correct, but it is the latter group that is the more scientific measurement, although not necessarily the more important one.

 

But there is another, more interesting argument at play.  It is claimed that the Fed is monetizing the debt by buying Treasury bills and bonds, and this is at the heart of the present criticism of the Fed's monetary policy. It is this that leads free market commentators to predict progressive inflation.

 

The concept of monetization assumes that, for example, if gas prices rise, an indirect “tax” will be imposed on the economy. As consumers have less to spend elsewhere and dollars flow out of the country to pay for higher oil imports, there would be a natural deflation. If the Fed increases the money supply to offset this deflation, it is considered monetization. If they go overboard and allow the increase of money to increase too fast and too far, it has the potential to become progressive inflation.

 

Another form of monetization would be if the Fed buys the government’s debt to finance the deficit. Once again this would increase the money supply and lead to inflation. Monetization is a deliberate policy that puts currency in the hands of individuals to afford goods and services that they would not otherwise be able to afford. The Fed argues they are doing no such thing.

 

The Fed is not allowed to buy Treasury bills directly from the Treasury.  They cannot, by law, pay the bills of the government.  They must buy in the secondary market.  The influence of Fed intervention in that market is low because the secondary market is huge, where the new issuance market is not.

 

 If the Fed were to by 30 billion dollars of a 50 billion dollar new issue of Treasuries by the government, that would have a huge affect. The Fed would be buying most of the government’s debt. But they are not allowed to do that. This is what many do not understand. The new money created by the Fed goes to neither the government nor the consumer. It enters the system via bond dealers who the Fed buys from who in turn deposit the proceeds in their checking or saving accounts, called M1 and M2 accounts.

 

And here is the most important point: until the new cash shows up in the M1/M2, and velocity picks up in the form of increasing amounts of money and credit chasing goods, there cannot be any new inflation of consequence.  Money is a medium of exchange.  If money is not chasing goods, across the board price increases are not possible.  Currently there is no evidence that the money supply is increasing
abnormally. You can verify these figures at the Federal Reserve St Louis Fed site http://www.economagic.com/em-cgi/data.exe/fedstl/day-wm1ns (Check M1 and M2 from October of 2010 to the present -- the period of QE2).

If the money supply is not increasing much, where did all of new money the Fed admits to creating go?  It is lying dormant as excess reserves in our banking system. It can all be accounted for at  http://www.economagic.com/em-cgi/data.exe/frbH3/day-t05s07. The banks have taken this money and held it as additional reserves rather than lending it out. By increasing their excess reserves, banks have neutralized the Fed's new money creation.  If these reserves begin to eventually re-enter the money supply as new purchasing power in the form of high powered money, gunned by the multiplier effect, (which is the fear of those condemning the Fed’s monetary policy), the Fed intends to sterilize it. That is their exit policy. “Excess reserves can be brought down without any significant economic or monetary consequences as fast as they were put in – and faster if necessary.”  --Alan Greenspan on CNBC, last Friday.

 

This is entirely different than trying to contract the money from M1 and M2. A contraction of money deprives citizens from having money to use. That is deflationary. Preventing its use in the first place is not. Today, for the most part, the money the fed has created is not being used. This is why when Bernanke was asked "how sure are you that you can implement your exit policy effectively when necessary?” he answered “100% sure.”  He has thought this through and knows what to do when the time comes.

 

One thing that is assured is that once this experiment is over, the consequences for monetary policy is going to be huge going forward.  If the Fed pulls off a non-inflationary recovery, which most free market economists think is impossible, and things return to normal, economists are not going to view money in quite the same way ever again. New ground has been broken in banking and monetary theory. This particular tactic of monetary policy has never been used before. I believe it is working and the Fed will get pretty much the result it wants. If it does not work, however, the loss of confidence in the Fed that could result has the potential to end the Fed as we know it and even the present monetary system the world has been on for a hundred years. And this is why this argument is so important. The stakes are extremely high.

 

But the argument does not stop there. Some contend that the dollar in international markets is in jeopardy and that is where we will feel the inflation.  Yet, this is theory, not fact. The dollar, while lower, is not substantially changed from a few years ago.  There is no evidence there is a movement away from the dollar into other currencies, except perhaps toward gold and perhaps the Canadian dollar which are both small markets. Almost all the major central banks that hold dollars continue to do so – and are even increasing their holdings. Click here: http://www.treasury.gov/resource-center/data-chart-center/tic/Documents/mfh.txt  Even Switzerland is increasing their holdings of dollars.
 
Further it is not America that has an inflation problem; it is most other countries around the world. One reason is that the dollar has not fallen lately.  In 2008, in the months before the financial crisis, the dollar traded at between 70 and 76 according to the dollar index. http://stockcharts.com/h-sc/ui?c=$USD,uu[w,a]wahlynay[pc5!c65][iUg!Lf]&pref=G. Today it is trading at over 77.
 
Nor is there evidence that commodities are going up due to dollar depreciation as is being widely touted. Commodities are going up in ALL currencies.  If gold or other commodities were rising in dollar terms only, then yes a case could be made.  But they are not.  Commodities are rising in all currencies about equally.  So, it cannot be argued that it is a Fed induced condition. No one has shown how the Fed’s increase in new money has flowed abroad to chase foreign goods and services. That is because it is an allegation, not proven fact. Further the CRB, a composite of major commodities, is trading today at 354 down from 440 just prior to the crisis in 2008. http://stockcharts.com/h-sc/ui?c=$CRB,uu[h,a]waolynay[df][pc13!b50!b200!f][iLa12,26,9!Lv20]&pref=G
If commodity “inflation” is so great, why is the commodity index lower today than a few years ago?
  
Others claim that it is speculation from an intentional Fed policy to depreciate the dollar, that has driven dollars into the futures markets and resulted in a commodity boom. Yet there is no data to support this. Speculation has increased, but on both sides of the trade; long and short. We have seen more money going into commodities for sure, but this is a shift in money. ETF’s are creating greater demand for commodities, as is wealth fund hoarding. This is a worldwide phenomenon, not a Fed created phenomenon. Certainly the Fed is not responsible for oil disruptions in North Africa and the Mid East, or the supply disruptions in crop production due to weather related events, or the growth of population and wealth.
 
Meanwhile, capital requirements have been raised worldwide.  Leverage is being reduced worldwide.  De-leveraging continues here and abroad, and that reduces the degree of the potential rise and fall of markets in the future.  This is not the leveraged world of 2007-08. Dramatic swings in prices will no doubt continue, but without the repercussions of the hugely leveraged days past. We still have too much leverage and too little capital, but the direction is toward lower ratios, not higher.
 

The fact is, we are experiencing almost exactly what we experienced in 2008. History shows that huge swings in commodity prices can occur without a major inflation or deflation.  Gas went to four dollars a few years ago, fell to 1.89 and is back up approaching 4 dollars again. But there has been no generalized inflation or deflation as a result. It did not spill over to 2009, 2010, or to the economy today. Overall inflation remained unusually low during that entire period even with high commodity prices.

 

Inflation rates did go up during that period, but temporarily. They eventually declined so substantially that the Fed was more concerned with deflation just six months ago. We are about to see the CPI increase dramatically due to the present spike in food and gas prices.  There will no doubt be a barrage of e-mails telling everyone that we are going into hyper-inflation. But the question is will the rates stick, or recede as they did before?

 

If the Fed has been monetizing the debt since QE1, we should have seen what we did in the 70's -- a progressive increase in prices across the board.  Back then, the Fed increased M1 and M2 to finance both the Vietnam War and higher oil prices. That was real monetization. Prices rose from 2% to 12%. In 2008 the Fed increased the money supply, and did not monetize it, and we did not get progressive price increases. The Fed learned from their mistakes of the past and insist they will not make the same mistake again.

 

The preponderance of the evidence shows that the Fed is conducting a reasonable monetary policy. It is not monetizing the debt.  Will the debate stop?  Not a chance.  The debate will rage on despite the facts, and only after all has returned to normal will critics fall silent. History and reality will be the final judges and render their verdicts -- as they always do.

 

Market Update:

 

Last week I said I thought we were due for a correction -- well, things happen fast now-a-days.  I sold out trading shares of my top 3 holdings 1 week ago.  In that time we have had a 10 to 30% correction in some metals, and resource stocks, most notably copper.  Copper sold off from about 4.60 to 4.06.  Copper Fox, of which I sold out a third at 1.86, fell to a low of 1.29 today.  Freeport Mcmoran, FCX, fell from 61 to 47.25.  I decided that FCX is the next trading vehicle I want to utilize and put almost all funds into that stock at 48.75, with a stop at today's low of 47.25.
 
I completed my buy program on DNN which has fallen dramatically with all other stocks and I laddered in as it fell.  And I repurchased Amazon Mining Holdings, which if you remember, I bought at 6.50 and sold about a week later at 8.50.  I just bought it back at 7.65, and am looking to add more if it falls back to 6.50.
 
I hope the correction is over and we can proceed higher.  I have gone from a decidedly biased position in gold stocks to overweight in silver stocks, and now, to copper stocks.  Almost half of my portfolio is now tied to copper.

Portfolio by weight:

Freeport Mcmoran

Copper Fox Metals

Coeur d'Alene Mines

Rubicon Minerals

US Silver Corp
 
Lexam Gold

Denison Mines

Rochester Resources LTD