ECB Good, Federal Reserve Bad

Today the European Central Bank (ECB) announced it was raising its interest rates from 1% to 1.25%. Given that the European economy, particularly the economies of Greece, Italy, Spain, Portugal, and Ireland, are supposed to be in poor shape, that may seem like a dramatic tightening of the screws. It is not. Interest rates are still very low in Europe. Any shortage of credit, or of takers, is not due to interest rates being too high. 1.25% should provide good support to further economic expansion.

In contrast in the United States of America the Federal Reserve Board (the Fed) recently left its benchmark interest rate at zero. That is right, 0%. I admit I would like to borrow some money at 0% interest, but the Fed alone lends to its member banks. The same people who charge you 15% to 35% interest on credit cards. This unprecedented low American interest rate did not make much sense even during the Panic of 2008. 0.25% or 0.5% would have been just as supportive to the economy and the banking system.

We are now in a pretty ordinary recession, except the prices of certain commodities have spiked due to global demand and limited supplies. The Fed's public argument is that the low rates are because a lot of Americans are out of work. One thing I know, the Fed does not care about the type of Americans who are out of work, unless they are banking CEOs. They are keeping interest rates low for the benefit of the banks, of the federal government (it keeps interest on the national debt low), and for large corporations that can currently borrow vast sums of money at huge rates. In my role as analyst I have not seen much corporate borrowing used for industrial or work force expansion. It is typically used to buy back stocks or mergers.

The dangers of these unprecedented low interest rates are so clear that even a few Fed board members have pointed them out. They can lead both to inflation and to more asset bubbles. We certainly already have a gold and silver bubble. Bubbles were the problem in the first place. New bubbles do not a sound economy make.

Meanwhile, ordinary savers are suffering from low interest rates. Retired people are having to eat their principle because they are getting almost no interest from CDs and bonds. The Fed says there is no inflation, but if your main discretionary expenses are gas and food, there is a lot of inflation. Other recessions were not met with such low rates.

Since 1952 the Fed had set interest rates below 2% for only a few brief periods, before 2008. [See Federal Reserve rate history] Given that the Fed should manage for the long term (not acting like Wall Street traders who can't see beyond the current quarter), the Fed's rate should already be at 2%.

Given that (at least in free market theory) private loan rates should be set by supply and demand, that should not budge rates for housing. Anyway, low interest rates have failed to provide an incentive for people to buy homes. Homes are seen as a bad investment; people want easy money, not assets that are taxed yearly (with real estate taxes) and need to be repaired regularly.

The Fed are cowards. They don't want to tick off Wall Street or Congress (Republicans want low rates for their business friends, Democrats because they don't understand economics). 2% is very supportive of economic expansion. If we had already gotten there gradually (or were near there like the ECB is now), then further gradual adjustments could be made, up or down, depending on the genuine need for credit for economic expansion, or on the danger of inflation.

If I were the President (fat chance) I'd fire the bums on the Federal Reserve and hire some people who can actually do the job.

Data: ECB interest rate press release April 7, 2011

The Gold Bubble

I correctly called bubbles in the stock market in the late 1990's, in the housing market, and in oil [See Oil Bubble to Burst, [March 11, 2008]. I believe there is a bubble in gold right now. I am not saying the bubble will pop soon, or at what price; seeing a bubble is a lot easier than saying when it will pop.

The magic of gold is purely psychological, and mainly a historic artifact. Gold is pretty and does not tarnish, so it makes nice jewelry. It is just uncommon enough that finding and mining it is usually not easy. Hence when money was invented, gold was adopted for use in coins.

Gold has more uses now. Of course it is used in dentistry. Its main use, besides jewelry, is in electronics. Gold is an excelent conductor of electricity, and does not corrode, so it is used to plate contacts on the best-quality electronic products. Because they are much cheaper, silver and copper are more widely used.

Gold investors often believe that gold is the ultimated measure of value. But its intrinsic value is negligible. If it were more common it might be regarded as a cheap anti-corrosion metal.

A lot of gold is being hoarded around the world. As in typical in auction markets, as long as the price is going up, people are given incentive to hold onto their gold stock, no matter how high it goes. That is how auction markets create bubbles.

But study history and you will find there have been many times and places where gold was not highly valued in comparison to other commodities. If something else is desirable enough, it is worth its weight in gold. Famously, salt was once traded in some places in Africa weight to weight with gold.

A new gold find can cause gold inflation. This happened when the Spanish stole the gold of Mexico and Peru in the 1500s. Europe at that time could not aborb that much gold, so the price of gold relative to other commodities swooned. Much of the gold migrated to China and India, which then had far more robust economies than the European nations.

The ratio of the price of gold to silver used to be a big, big deal back when money mostly meant metal coinage. It was the prominent issue in the U.S. Presidential campaign of 1896, in which the Democratic Party "declared for the unlimited coinage of silver at the ratio of sixteen ounces of silver to one of gold, though the market ratio was about thirty-two to one" as a means of getting more money into circulation [The American Pageant by Thomas Bailey, p. 599]. The Republican Candidate, William McKinley, won the Presidency after his campaign outspent his pro-silver rival sixteen to one.

Today, as I write, the quoted values of ounces of gold and silver are $1141.30 and $18.42. That gives a price ratio of about 62 to 1. Historically they have mainly fallen between 10 to 1 and 40 to 1. So if history is any indicator, either the price of silver has to skyrocket or the price of gold has to plunge to get us to equilibrium. It is possible that when the bubble bursts both will plunge in tandem.

One relatively sound source of gold's strength has been the weak dollar. The theory is that gold stays stationary in value. Therefore, if the dollar falls, the value of gold in dollars should rise. Of course normally financial brains would see right through that simple equation. The dollar should fall against any currency that rises against the dollar, if the theory were valid.

More fundamental is the usual fall in the value of goods versus currency when there is slack demand. In other words, deflation. There is concern that the astonishing amount of fictional money pumped into the American economy by the Federal Reserve starting in 2008 is going to cause the opposite, a great inflation. So the high price of gold, under that theory, is about looking ahead to the coming inflation. But the newly pumped money, so far, has not even replaced the money that dissappeared in the Great Panic of 2008. So it is a bit early to place heavy bets on inflation. If the Fed starts raising interest rates in 2010, and raises them fast enough, inflation should be held to its normal pace.

Like everything auctioned, the price of gold at any given time is highly dependent on the dynamics of the auction system. On an upswing people have every reason to delay selling in order to get higher prices at a later date. This in itself can create shortages that cycle into higher prices.

But there are always mini-cycles within the larger cycles. No one thinks much of a drop of a few pennies in the price of gold during the course of a trading day.

During a bubble at some point enough people will bail out to drive down the price of the asset enough for other holders to notice. If this trend become prolonged or deep, all the theories in the world won't support the price of the asset. Once gold starts falling consistently, people will realize it is not a magical store of value. They will trade their gold for something they can actually spend or invest more profitably.

Of course a gold bubble could also be popped by the discovery of a new gold field.

What confirms for me that we are in a gold bubble is that normally, during a severe recession, all asset classes are sold by investors. Gold should have come down subtantially in price in 2008 and 2009. Perhaps gold investors are more conservative by nature than those who invest in asset classes, so that they were not leveraged, and did not need to sell. I don't get that impression from the few big-time gold bugs I have met, but some times anecdotal evidence is misleading.

Remember, gold could go a lot higher before the bubble bursts. Shorting gold is no more a sure thing than going long on it.

Hedge your bets: keep diversified!

William P. Meyers

To The Federal Reserve: Start Raising Interest Rates

The Federal Reserve should have set its "federal funds" rate at 0.25% at its last meeting. Unless there is a marked reversal in the economy, it should raise the rate to 1% in steps.

Confidence in the Federal Reserve is near zero at this point. We have had two major asset bubbles in less than a decade. While there were other reasons for the bubbles, the main reason the bubbles grew to catastrophic proportions was the failure of the Federal Reserve to raise rates quickly in response to the bubbles. True, there should have been better oversight of the mortgage industry and the derivatives based on it. But when an economy as a whole inflates unreasonably, it is the money supply and interest rates that need to be controlled.

The Board of Governors of the Federal Reserve current policy is to "maintain the target range for the federal funds rate at 0 to 1/4 percent." [See August 12, 2009 Federal Reserve meeting release]

One of the causes of the crash of 2008 was inadequate consumer savings. Because most consumers had little of no savings, when credit was reduced they had little or no ability to keep consuming.

Since the Fed lowered interest rates to deal with the crash it should have prevented, those who did save by putting deposits in CDs and saving accounts have been severly punished. True, they may be happy that they were not invested in stocks or speculating in real estate, but as time passes the punishment becomes more real. It must be particularly gauling to get a notice that you credit card interest rate has been raised to over 20% from the same bank at the same time your CD renewal rate is lowered to 0.5%.

There is something obviously corrupt, and diverging from free market pricing doctrines, when the Fed is lending to banks (at the discount rate) without charging interest, and the banks are turning around and charging over 20% interest to the citizens of the United State.

But if you can, forget about justice for a moment. Consider the economic implications of the Fed's current policy. Money costs nothing to those borrowing directly from the Fed. What are the chances that free money will be allocated in an economically efficient manner? Zero, the same as the interest rate.

The biggest problem, however, is that the Fed is signaling that it does not care about inflation. With global supplies of oil, grain, and other basic commodities likely to tighten quickly once the global economy starts expanding, the danger of inflation from commodities alone is high. In addition, the Federal deficit and debt are huge indicators of potential inflation.

It is unlikely that a Fed funds rate of 1% would derail a recovery, even if such a rate had been announced in August. Putting 1% gradually into place is no danger at all. The danger is that the Fed will, yet again, get behind the curve and then be forced to overreact. The even greater danger is that the Fed will get behind the curve and then fail to ever catch up without causing a crash, as happened in 1999 and 2007.

Even if the economic recover is gradual, there is no reason to have rates below 3% by the end of 2010. High interest rates reward savings. That is not just putting money in a savings account. That is thrift, doing things efficiently, doing without waste or luxury. High interest rates also punish borrowing, which is associated with economic inefficiency and waste.

You can let the Federal Reserve know what you think at Federal Reserve Feedback.

Oil Bubble to Burst?

Noticing that there is a bubble is no big deal. I noticed that there was a stock market bubble in the late 1990's. I noticed that there was a real-estate bubble in the mid 2000's.

And I've noticed that there is an oil bubble that started a couple of years ago.

But calling an end to a bubble is difficult. How do you know when investors are going to collectively realize that all their stocks can't be the next Microsoft?

And given how irrational the Federal Reserve has acted in the past 20 years, even though you could predict that the housing bubble would burst when the Fed raised rates high enough, there was no way to predict when the Fed would get around to acting.

We are in an oil bubble. But that does not mean that the price of oil can't go higher, or that it might not take years instead of months for it to burst.

Consider the counter-argument: the globe has reached peak oil production, but demand is still rising rapidly, so prices will continue to be pushed up.

I believe it is likely that we have reached the vicinity of peak oil production, but Saudi Arabia could flood the global market with oil tomorrow if it desired to, and keep the flood running for at least a couple of decades.

Demand is already being pinched, but converting from oil to other energy sources, or to conservation, is a slow process. Yet it is happening. Talk to any car dealer in the U.S. about what has been selling in 2008, and they will tell you: fuel efficiency. People are sizing down. They are going to size down through all of 2008, and in 2009 Americans will be using a lot less gas.

True, demand in India, China, and other developing countries will increase. But these nations are also rapidly adopting non-oil based energy technologies.

Consider Applied Materials (AMAT) [disclosure:I own this stock]. It sells a line of solar panel factories. That is, it makes all the tools you need to make massive, low cost solar panels. You build a big building and move in one of the factories. You spit out solar panels. Another company paves large sections of the earth with them. Soon all-electric cars will run on the energy from these massive solar installations.

Multiply that example by a thousand other innovative companies and the practical decisions of billions of individual consumers, and you have demand for oil that is drying up. In addition, there is plenty of oil and gas. Do you see people lined up waiting for gas? No. There are no shortages. At least half of the current price of oil is pure speculative fever.

Maybe it is a good thing. Maybe these speculators are doing more to ease global warming than the federal government ever did or ever will do. But if federal taxes had been used to raise gasoline prices to today's level, we would not have a huge federal budget deficit in addition to our other troubles.

I can't say when the bubble will burst. And artificial shortages, like the one caused by the Iraq war, or Enron's gaming, could be created.

Meanwhile real estate is reasonable and stocks are dirt cheap. Food is another matter. We are in that part of the Malthusian cycle when there is not enough food for all the people who have procreated. If you bought sacks of flour last year your return today would be better than most managed stock funds performed.

It is a strange, new world. The pace of change in the 20th century will prove to be nothing compared to changes this century. And one change is coming fast: the end of the Oil Era.