Tuesday, January 12, 2010

Investment Demand Returning

A brief article in the South African BusinessReport Online says that gold is being re-monetized - meaning, that investment demand is overtaking jewelry demand in the gold arena. The article mentions a seventeen-year cycle for gold.

If that cycle holds up, we're more than half-way through it. Gold's been in a bull market for close to nine years now. To be frank, the politics of inflation - the risk of future inflation being bearable given the alternative of a deflationary collapse - suggest that the gold bull will continue. Paul Volcker may be a paragon of central banker rectitude, but he has a political radar. All heads of central banks do. Back in 1981, the pain of inflation was both evident and immediate. Warnings of future inflation were piggybacked on crowings about earlier vindications. It was seriously believed that the bond market was wrecked. And yes, there were lots of complaints about inflation. The "misery index," which Ronald Reagan used in the 1980 campaign, was unveiled at that time. Its misery metric was the unemployment rate plus the inflation rate.

Mistakes may still be made, but it's more characteristics of U.S. politics to assume that the monetary authorities were caught napping in '08. They won't make that kind of mistake again. The bulk of the Fed's quantitative-easing program has been the purchasing of mortgage-backed-securities. Those MBSs are all guaranteed by governmment agencies, and the U.S. government itself has pledged to make up all losses suffered by Fannie and Freddie to an unlimited amount. Obviously, one of the motives is to protect the Fed from taking losses on the MBSs it bought.

There's only one reason why the Fed would have dove into the MBS market: to keep mortgage rates lower than they otherwise would have been. One of the talking points in the credit-doomster crowd has been the resetting of option ARMs, which is expected to peak next year. The Fed's intervention in the mortgage market signals quite clearly that they themselves know about it, and are holding down rates so as to minimize the damage of those resets.

There is one counterargument to inflationists that so far has been telling: the Fed is sterilizing its interventions so as to not create serious inflation down the road. The ballooning in the monetary base has not been reflected in the money supply itself; M2 growth has been modest, even if M1 growth hasn't. Recently, the Fed has announced a program to let banks lend excess reserves to the Fed itself in a term-deposit scheme. They doing so signals that more quantitative easing is coming, because they now have a mechanism to explicitly "sterilize" any further bank-reserve ballooning. So far, the sterilization has been implicit; now, it won't be. Thus, at least in theory, they can buy more securities without it causing inflation.

Will the deflation-fighting end nicely? Likely, no. The underlying odds not only say that the monetary authorities take decisive action once they finally wake up, but also says that they'll overreact. That bodes well for inflationism down the road, even if the implicit sterilization of the reserves expansion has not boded well for them so far. As noted above, inflation is low on the U.S.-economy problem list right now.

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