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Wednesday November 2, 2005 - 11:48:22 GMT
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Is the Fed right?


“A general rise in prices can only occur if there is either a drop in the supply of all commodities or an increase in the supply of money (in the broader sense).”

Ludwig von Mises

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Once again the Fed tells us that inflation isn’t really that much of a problem. But…

“If America's creditors sense that inflation is robbing them of their wealth and that the Bernanke Fed is too slow to raise its interest rate, they will sell their dollars and dollar-denominated securities. Such an exodus would, among other things, tend to increase the costs of imported goods and drive up dollar-denominated interest rates. In other words, events would control the Fed.

“Since each of the world's major currencies is a scrap of paper of no intrinsic value, some of these disaffected dollar investors may buy gold. Mr. Bernanke doesn't talk much about that barbarous relic. What would he make of a flight from a rationally managed currency into an inert precious metal? I will guess that it would astonish him,” opines Jim Grant in the New York Times recently.

What do we make of the inert precious metal and the lowly Federal Reserve Note dancing to the same tune of late?

Does the rally in gold AND the dollar imply the market is more or less confident in the ability of the Fed to manage circumstances?

The dollar is getting plenty of yield support, yet is seems the short-end of the curve has been the real driver. The chart below shows Eurodollar interest rates rise (shown as inverted futures prices in the chart below) versus the dollar.

Why do we say the short-end seems a better driver for the dollar here? Two reasons: 1) the yield spread continues to converge (between short and long rates), and 2) the aggressive move in the short-end may sow the seeds of the destruction of yield on the long end.

Maybe we get the inversion that Bond King Gross, and others are expecting. If so, wouldn’t that be evidence of inflation premium being squeezed out of the long end of the curve? Does this imply the Fed is right—inflation is contained? Or does it imply they will MAKE it right by moving short-rates deep into the restrictive zone even though they say inflation is “contained”?

Is it all a bunch of circular reasoning? Are the comparisons we tend to make simply of the short-term coincidental variety? Not sure, but if we think the dollar is being supported by the short-end AND we think the Fed could be right—then we would expect more players to capitulate to the dollar bull view.

But, this view is predicated on our consensus view of the Fed as an institution with a degree of prescience we shouldn’t bestow upon it.

Prices in the real world are a SUBJECTIVE measure of exchange value, and these values constantly change through time, AND money is much more than “neutral”. Yet the Fed and most Ivy League economics departments (they still love the General Theory, does anything more need to be said) still believe in some theoretical construct of stable prices and neutral money. In the real world, can a single policy tool—the Fed Funds rate—really be a consistent guide to existing market conditions?

Jim Grant sums it up this way:

“Let us say that Mr. Bernanke's field of expertise was energy prices rather than interest rates, and that the president named him to the Department of Energy rather than the Federal Reserve. If Mr. Bernanke then ventured a long-term oil-price forecast, would anyone even bother to write it down? Would anyone expect him, once confirmed, to actually fix the price?

“Those who did would have to call the idea by its discredited name - price controls - and would have to explain why the secretary-designate knew better than the market at which price the supply of oil would meet the demand for oil. They would also have to explain why this episode in price controls would turn out better than the long series of flops that preceded it. The world would laugh.”

Bottom line: Sooner of later we expect monetary dislocation to show up in the price of gold. Not just because of the massive global imbalances and financial leverage, but because faith in the Fed has reached a speculative extreme.

Jack Crooks
Black Swan Capital


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