GDR iii
Gold & Inflation
Eric Hommelberg
April 4, 2005
Gold & Inflation is chapter
III of the Gold drivers 2005 report. It discusses the possibility
of Inflation picking up steam and how it could affect Gold. Signs
are surfacing everywhere that inflation is picking up steam indeed.
The Producer Price Index remains above the Consumer Price Index
for almost two years now which doesn't bode well for the CPI.
Rising Oil prices are here to stay and will translate itself
into a higher CPI. As long as the FED doesn't raise interest
rates fast enough in order to contain Inflation, real rates will
stay negative or extreme low. History suggests that negative/low
real rates are on of the strongest drivers for the price of Gold.
This chapter will
focus on:
1. Current
Inflation numbers reliable?
2. Future Inflation
3. Higher rates as a result of a dropping dollar
good for Gold
4. Negative real rates and Gold
1 - Current Inflation
numbers reliable?
Although official inflation
statistics do suggest that inflation is well under control, the
opposite seems to be true. Just ask people if they are happy
with sky-rocketing food, energy and health care prices and you'll
get an idea. Hedonic adjusted Pentium IV processors won't cure
the pain felt in consumer pockets. Needless to say that over
90% of the American public don't believe the official inflation
statistics and neither does PIMCO's managing director Bill Gross.
Bill Gross on adjusted inflation
numbers:
"Talk about a con job!
The government says that if the quality of a product got better
over the last 12 month that it didn't really go up in price in
fact it may have actually gone down! For instance, prices of
desktop and notebook computers declined by 8% a year during past
decade. The WSJ reports but because the machines computer power
and memory have improved, their hedonically adjusted prices have
dropped by 25% a year since 1997. No wonder the core is less
than 2% with computers dropping that much every year."
"Actually, to make the
case for a government con job, it's important to point out that
the bulk of these hedonic adjustments have come only in the past
few years, when it became necessary to buttress Greenspan's concept
of our New Age Economy."
"Today no less than 46%
of the weight of the US CPI comes from products subject to hedonic
adjustments. PIMCO calculates that without them they would be
between 0.5% and 1.1% higher each year since 1987." END.
Ok you'll say, the government
can mess up with so many goods by means of hedonic adjustments
but what about oil and gasoline? Higher oil/gasoline prices should
be reflected in the government PPI/CPI numbers shouldn't they?
Well, they don't! The government just reports LOWER oil/gasoline
prices instead of the real figures. You don't believe it?
Bill King (from the King
Report) reported in February this year:
The big rally in oil and gasoline
is not reflected in the January PPI. BLS actually has energy
prices down 1.3% for January, with crude energy prices down 4.5%!
Absurd! The below charts show crude oil rallied from the low
to high $40 handle; gasoline and heating oil surged while natural
gas traded sideways. END.
The next day he continued:
We have been ridiculing the
CPI for years. Yesterday's CPI report is yet another bogus
accounting of inflation. Energy prices fell 1.1% after
falling 1.3% in December. Gasoline fell 2.1% and heating
oil fell 5.2%. Gasoline prices are down 20.2% over the
last 3 months annualized. Food & beverage prices fell
4.6% in the CPI-U (Urban) table while fuels fell 4.9%.
Public transportation prices fell 0.8%. You saw the energy
charts in yesterday's missive. This is absurd.
Absurd indeed when the following
Headline appears in the media:
US gasoline price breaks
$2 a gallon, AAA says
The U.S. government projected
that gasoline prices will hit a new record high this spring,
reaching a national monthly average of $2.15 a gallon. END.
Well, they didn't have to wait
for long:
Gasoline prices hit nationwide
record
Fri Mar 18, 6:13 AM
ET
Gasoline hit a record nationwide
average price of $2.055 a gallon, motorist club AAA reported
Thursday, creeping up 0.2 of a cent overnight to eclipse the
previous high of $2.054 last May. END.
So we have a government here
projecting record high gasoline prices although they are trending
down according to their own PPI/CPI statistics. To make things
even more absurd just take a look at the table shown below
posted at LemetropoleCafe.com. It displays the actual monthly
average prices vs the Government reported prices.
Well, this table says it all,
the government doesn't report the real numbers but LOWER! They
do that in order to keep inflation rates low, it's as simple
as that!
Conclusion: Inflation is
actually higher than reported.
Another expert agreeing with
this thesis is professor Campbell R. Harvey (Duke University)
Prof Campbell R. Harvey:
March 23, 2005
"I believe we have a more
serious inflation problem than is widely acknowledged in the
market," says Harvey.
The Producer Price Index (PPI),
an indicator of wholesale prices, has been running above the
Consumer Price Index (CPI) since March 2003.
"This is ominous,"
Harvey said. "On a year-over-year basis, the PPI exceeded
the CPI in 2000, 1989, 1978 and the last half of 1972. When this
happened over a sustained period, a recession has followed."
"The economic story is
straightforward. The PPI is an advance indicator of consumer
price inflation. It takes a while for the prices of production
goods to work their way through the system and into consumer
prices. The high PPI indicates substantially higher consumer
price inflation in the future," Harvey said. END.
So we have higher Inflation
than reported by government but for what reason inflation must
reported lower than actual?
Bill Gross:
"Alan Greenspan has a
dual prerogative at the Federal Reserve. He is charged with keeping
inflation low and economic output high. The magic of hedonic/substitution
adjustments keeps both of these birds flyin' at the same time,
one under the magical 2% radar, which marks the dividing line
between benign and worrisome inflation , and the other (real
GDP), over the hurdle of 3% which suggest the continuation of
high productivity."
"My sense is that the
CPI is really 1% higher than the official numbers and that GDP
is 1% less. You're witnessing a 'haute con job'." END.
Despite all the hedonic adjustments
Inflation is getting noticed these days:
Manufacturers hike prices
to offset commodity costs
NEW YORK, (Reuters) - Industrial
manufacturers, who until recently footed the bill for high raw
material costs, took advantage of surging demand to pass along
the increase to their customers during the second quarter.
U.S. stocks to open lower
as inflation data weighs
Tuesday November 16, 9:06 am ET
NEW YORK (CBS.MW) - U.S. stock
futures are indicating a lower open Tuesday as broadly positive
third quarter results from a slew of retailers including Wal-Mart
and Home Depot, were offset by concern over a surge in October
wholesale inflation to its fastest rate in 14 years.END.
CBS MarketWatch
U.S. stocks open lower on inflation, oil jitters
Friday December 10,
9:44 am ET
"NEW YORK (CBS.MW) --
U.S. stocks lost ground Friday as a sharper-than-expected
rise in producer prices for November raised concern about
a pick-up in inflation."
"Within the report, core
intermediate prices, a key leading indicator of inflation, has
risen 8 percent in the last year, the worst inflation since 1981."
END.
Food Prices in New York
in Biggest Leap in 14 Years
January 20, 2005
Consumer Price Index for the
New York region rose 3.8 percent as an overall average in 2004,
the federal government said yesterday, as higher food prices
and rising fuel costs drove the largest year-to-year increase
in the index since 1990.
Energy costs in the region
also increased last year - 14 percent over 2003 - but that was
less than the 16.6 percent increase nationally. Rising gasoline
prices continue to hurt the region; they rose 22.6 percent locally
in 2004.END.
Inflation is the main issue
of uncertainty in the U.S.
March 11, 2005
A major concern for Treasuries
is "the weaker dollar and the inflation piece of that story,"
said Ralph Axel, a U.S. government debt strategist in New York
at HSBC Securities USA Inc. "Inflation is the main issue
of uncertainty in the U.S." END.
With Inflation picking up steam
there is only one thing the FED can do and that's to raise interest
rates. According to Greenspan we shouldn't be surprised to see
the FED just doing that. On November 19 he said:
Greenspan, Nov 19 2004
"Rising interest rates
have been advertised for so long and in so many places that anyone
who has not appropriately hedged this position by now is obviously
desirous of losing money." END.
Indeed the FED is just doing
that (raising rates) and made it clear (March 22) that it will
continue to do so for the foreseeable future.
Conclusion: Inflation and
higher rates simply can't be ignored any longer.
A further enhancement to this
conclusion is given by the OIL/CPI graph. When CPI changes (Inflation
Rate) compared to Oil you'll notice that higher Oil prices never
existed without high Inflation rates but now we're witnessing
an Inflation rate which is lagging the price of Oil tremendously.
Higher Oil prices are permanent due to increasing demand and
flattening production curves so what gives? Oil prices coming
down or Inflation rates catching up? See graph below:
Stephen Leeb (president of
Leeb Capital Management and author of The Oil Factor
-Protect Yourself (AND PROFIT) from the coming Energy Crisis
said during an interview with Jim Puplava of Financial
Sense Newshour:
Sharply rising energy prices,
similar the the 70's, will lead to double digit inflation figures
over the next 10 years. It's going to turn the economy on its
head. END.
Chapter VIII Gold & Oil
goes into detail why oil prices will remain high coming years.
2 - Future Inflation
But what about coming years?
Maybe current Inflation issues are just temporary?
Well, according to Peter Peterson
and Laurence Kotlikof they are certainly not. Peter Peterson,
secretary of commerce during the Nixon administration and Prof.
Laurence Kotlikof, senior economist at the President's Council
of Economic Advisors (CEA) during the first Reagan administration,
published excellent books lately ( "Running on Empty"
, "the coming Generational Storm" ) in which they explain
in greatest detail why the US is heading towards bankruptcy.
They project a fiscal liability of more than 50$ trillion due
to the baby boomer generation who starts to retire as from 2008.
So a fiscal gap of $50 trillion+ is looming on the horizon but
the sad truth is that this amount of money isn't simply there.
So how to solve such a fiscal gap?
Kotlikof says:
"To close a $51 trillion
fiscal gap, "you'd have to have an immediate and permanent
78 percent hike in the federal income tax."END.
Kotlikof refers to a pathbreaking
study by Jagadeesh Gokhale of the Federal Reserve Bank of Cleveland
and Kent Smetters, a former deputy assistant secretary of the
Treasury Department (commissioned by former Treasury Secretary
Paul O'Neill). They came up with a few very painful solutions
on how to meet these liabilities:
More than double the payroll
tax, immediately and forever, from 15.3 percent of wages to nearly
32 percent;
Raise income taxes by two-thirds,
immediately and forever;
Cut Social Security and Medicare
benefits by 45 percent, immediately and forever.
Eliminate forever all discretionary
spending, which includes the military, homeland security, highways,
courts, national parks, and most of what the federal government
does outside of the transfer of payments to the elderly. END.
You don't have to be a genius
in order to understand that all of the items mentioned above
is a one way ticket to political suicide so don't count on them
to be implemented.
Kotlikof conludes:
The country's absolutely broke,.This
administration and previous administrations have set us up for
a major financial crisis on the order of what Argentina experienced
a couple of years ago." END.
But if this problem is so huge,
why don't we hear anything about it? Why wasn't it a hot issue
during the presidential debates?
Kotlikof:
Maybe the public doesn't want
to hear it. Maybe politicians think ... the American public can't
understand the truth or hear the truth or bear the truth. I think
this is garbage. I think that people care about their kids and
grandchildren and need to know the dangers facing them -- and
us. END.
But what happened with the
Gokhale report prepared for former Treasury Secretary Paul O'Neill?
Obviously Bush didn't like it and O'Neill got fired. The $44
trillion fiscal gap report went into the dust bin. O'Neill after
his resignation:
"It's all about sound bites, deluding
the people, pandering to the lowest common denominator,"
he said. "I didn't adjust (in Washington) and I'm not going
to start now."END.
Well, deluding the people,
didn't Bil Gross say something similar regarding reported CPI
numbers?
It should be obvious that the
US government is literally drowning in its debt (see also chapter
I Gold &US$) and this situation is getting more ugly year
after year. But somehow this debt situation HAS to be solved,
but how?
Kotlikof comments:
The most common way to renege
on official debt is to create inflation. For a quick tutorial
in how to do it, just drop by heaven, purgatory, or an even deeper
location that may be housing former president Nixon. Ask him
to tell you how he reneged on official debt to pay for the Vietnam
War. He'll tell you that he sold bonds to the public to get the
money to pay the military. Then he got his buddy Arthur Burns
at the Federal reserve to print money to buy back the bonds.
Sure enough inflation took off. Nominal interest rates, which
are used to discount the interest and principal, shot up, and
the real value of federal debt declined dramatically. END.
Does it sound familiar?
Deja Vu again! Inflate your way out of debt.
Kotlikof concludes that in
order to meet the fiscal liabilities exceeding $50 trillion you
need a budgetary resource that only inflation can provide. According
to Kotlikof the road to double digit Inflation numbers could
be something like:
Any day now, bond traders,
who, truth to be told, can be as tick as bricks, may start to
react to our official deficit that is now almost running at 5%
of GDP. Another flashpoint could be Alan Greenspan's retirement.
Greenspan has told the bond markets what to think for so long
that it's largely forgotten to think on its own. His exit could
prompt a reappraisal of the financial and fiscal landscape. The
sequence of events might run like this. Greenspan leaves. The
dollar slides. Long-term interest rates rise. The Congressional
Budget Office issues a warning about fiscal sustainability.
The IMF comes out with a similar report. Long-term interest rates
rise some more. Inflation picks up owing to higher import prices,
which is due to the weaker dollar. Long term interest rates move
into the double digit range. The stock market tanks. The federal
reserve prints money to lower rates, but this raises Long-term
rates even further. The economy moves into recession. Deficits
hit 7% of GDP. Inflation hits double digits. The government cut
taxes in a desperate attempt to stimulate economic activity.
Japan and the EU look shaky. And we're off to the races. END.
So several potential flashpoints
could trigger the whole thing. As Kotlikof points out bond traders
might react to the official US deficit exceeding 5% of GDP. Why
this is such an important threshold is described in detail in
chapter I Gold & US$.
Bill Gross points out:
"It's another way of saying
that U.S. yields depend upon the kindness of strangers and that
the time to not own them is when the strangers become less kind.
I suspect that is just around the corner but Beijing and Tokyo
have the ball in their courts."
"Wherever that should
occur, there's no doubt that the dollar is on the run and that
higher U.S. interest rates are the inevitable consequence. Dollar
depreciation leads to higher inflation and ultimately forces
foreign creditors to question their rationale and indeed their
sanity for continuing purchases of U.S. Treasuries. Investors
don't need necessarily "TOO MUCH" intelligence to do
this trade." END.
Well, as shown in chapter I
Gold & US$, selling of US$ is already the tune of the day.
Kotlikof concludes:
The US is doing all the things
that mark an economy soon to be wrecked by inflation and a weak
currency.
- We're running a large federal
deficit, however it is calculated
- We're cutting taxes so the
deficit will be larger for a longer period of time
- We're running a record trade
deficit. It continuous to increase in spite of a weak economy
- We're no longer a creditor
nation.
- We owe billions around the
world
- Our government doesn't seem
to care
- We have implicit liabilities
out the Gazoo
So what does Kotlikof suggests
in order to protect investors against upcoming Inflation?
Kotlikof:
Our response - and we're serious
- is to develop an interest in Gold and build an alternative
portfolio that will provide some protection from inflation and
a declining currency. END.
3 - Higher rates as a
result of a dropping dollar good for Gold
As said before, if long term
rates starts to rise and Inflation is picking up steam, the FED
simply has to start raising interest rates. Indeed the FED started
raising interest rates from a 40 year low of 1.0% but still has
a long way to go to catch up with more realistic inflation figures.
As Long as the FED stays behind the inflation curve real rates
will stay negative which have been according to its own history
one of the strongest drivers for Gold. The mainstream argument
that rising rates are the death for Gold (a rate-hike should
strengthen the dollar and therefore be bearish for Gold) is simply
a lie. Rising rates as a result of a dropping dollar is very
Gold friendly. What does history say about rising rates and Gold?
Well, you'll certainly remember the latest bull market in Gold
from 1970 to 1980 right? So what did interest rates do during
that period? Indeed they rose!
Yes, the 10 year yield rose
from a mere 5% from early seventies to an astronomical high of
15% in the early eighties! What did Gold do during this period?
It rose from $35 all the way up to $850. From the early eighties
till 2000 the 10 year yield came down again from 15% to 5%. What
did gold do during this period? It came down all the way from
$850 to $255. Just look at the chart of 10 Y TSY and judge yourself:
rising rates are the death for Gold is simply a lie
4 - Negative real rates
and Gold
Don't expect the FED to raise
short term rates aggressively. The debt situation is too bad
in order to absorb sharp increases of interest rates. Financial
institutions like Fannie Mae and Freddie Mac won't appreciate
sharp rising interest rates. They are scared to death for
sharp rising interest rates. And yes, a default of one of these
giants can buckle the US$!
Should we take this risk serious?
Well, earlier this year in just a matter of weeks, Greenspan,
Snow and Fed governor Pool issued strong warnings regarding these
financial giants, you really think this is without a reason?
Fed governor Poole:
"While there is no crisis
evident for the obligations of the housing government sponsored
enterprises, their capital positions were "undesirably thin"
and leave the firms "unnecessarily vulnerable to surprise
shocks."
He said clear procedures for
closing either company in a crisis should be established.
"Should a crisis occur,
it will take hold so quickly that GSE obligations will in a matter
of hours, or days, become illiquid. While any one holder of GSE
debt can exit, not all holders can exit at once," END.
What kind of consequences a
crisis at Fannie/Freddie could unfold according to Pool?
"There is no question
but that a crisis affecting either Fannie Mae or Freddie Mac
would have widespread effects because these firms are so large,"
Poole said in remarks prepared for delivery to a banking conference
organized by the Chicago Federal Reserve." END.
So a crisis at Fannie/Freddie
is certainly not an issue which will be celebrated by government.
Is a crisis imminent at Fannie/Freddie? Just repeat again the
following:
"their capital positions
were "undesirably thin" and leave the firms "unnecessarily
vulnerable to surprise shocks."" END.
What surprise shocks you think
he is referring to? Well, my guess is sharply higher interest
rates!
Alan Greenspan asked Congress
again in February this year to curb Fannie/Freddie's growth.
He said:
Going forward, enabling these
institutions to increase in size, we are placing the total financial
system of the future at substantial risk." However Al equivocated,
"The risk now is, as best I can judge, virtually negligible.
END
So with a FED not aggressively
chasing higher interest rates leads to long lasting negative
real rates. The inverse correlation between negative real interest
rates and Gold is perfectly illustrated by the following graph
created by Adam Hamilton of zealllc.com.
As Adam says this graph is
a grand strategic chart, which vividly illustrates just
how bullish for gold negative-real-rate environments truly are:
Indeed, this chart doesn't
need any further explanation. Negative real rates are powerful
drivers for the price of Gold, period!
Highlights:
- Inflation is picking up steam,
consumers do notice already for a long time
- Rising Oil prices are a significant
contributor to higher Inflation
- CPI is lagging Oil tremendously
today. History says that such an Extreme won't stay there for
a long period of time. Since Higher Oil prices are permanent,
CPI will catch up
- PPI continuously higher than
CPI for almost two years now doesn't bode well for the CPI. CPI
will catch up
- Future fiscal liabilities
exceeding $50 trillion requires a budgetary resource which only
inflation can provide
- Government still insists that
there is no Inflation, their statistics are getting comical
- Gold is the Ultimate Hedge
against Inflation
Germany:
Inflation 1923-24:
A Woman feeds her tiled stove with money.
She chose to feed the stove with Money
because it cost less than buying the wood with Money. April 01, 2005
Eric Hommelberg
email: ehommelberg@golddrivers.com
website: www.golddrivers.com
NOTE: Readers interested in future GDR updates can drop
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