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Crying All the Way to the BankMichael Pento The Fed has angered many and pleased few in its ongoing effort to unclog the credit markets. They have lowered the Fed Funds rate a total of 100bps to 4.25% in the last three meetings and have also taken the Discount rate down to 4.75%. Most market pundits clamor for the Fed to ease more aggressively in an attempt to bolster flagging market returns. Meantime, an increasingly rare strategist argues for a stable currency and low inflation. In light of the recent actions by our Central Bank, I thought it important to lay out the reasons why it would be better for our economy if the Fed allowed the free market to work. First let's make it clear what the Fed does when it intervenes in the market. When the Fed wants to expand liquidity, it effectively prints new money by purchasing bonds from dealers in banks. This has the effect of increasing the money supply while lowering the cost of funds. This process ignores the fact that money residing in the banking system should exist from deferred consumption (savings), not by fiat. Increasing the amount of money artificially results in ersatz savings and is always inflationary. So why the tears? They are for savers, people who live on a fixed income, and for those whose occupational salaries do not keep up with inflation. It is inflation that is the enemy, an enemy more pernicious than any recession elected officials fear. Two of the hallmarks of a country's strength are its savings rate and the viability of its middle class. During the beginning of the Reagan era, consumers had an 8% savings rate of disposable income. After turning negative for two years, it now stands at near zero. After all, why should we be a nation of savers if the purchasing power of our dollars will be eroded by inflation? In that case, it is much better to be a debtor. The average income in the U.S. has also been stagnant recently. According to IRS data, the average American consumer earned less in 2005 than in the year 2000. Not all Americans are affected in the same manner, however. Since the early 1960's, the top 1% of households have increased their net worth more than 50% over the median wealth in the United States. The main reason for the developing chasm between the classes is clear: poorer Americans hold less of the assets and investments that increase in value when the dollar is depreciated. They also tend to hold occupations in the low paying service sector, whose salaries do not increase with the cost of living. In the long term, it is better to have most Americans' standards of living increase rather than just a select few, and it is a stable and sound currency that allows this to occur. If you don't believe we have an inflation problem, just look at the facts. The official inflation numbers from the Bureau of Labor Statistics indicate that C.P.I. increased 3.5% Y.O.Y. from October 2006-2007, nearly the level at which President Nixon imposed price controls in August of 1971. Looking at the monetary aggregates, we see MZM (M2 - time deposits) currently rising at over a 15% annualized rate and M3 rising at an annual rate of 17%-- well above the levels experienced in the late 70's and early 80's. This inflation has caused the USD to fall 8.5% against the basket of our six biggest trading partners. The dollar has also lost ground against gold, of course, boosting the precious metal by 22% YTD. Wall St. continues to cheer for another rate cut to boost nominal returns in the major averages. However, if you adjust the S&P 500's return of 4.2% YTD and the Dow Jones return of 7.8% YTD for the falling dollar, the real returns are decidedly negative. An owner of the Dow Jones Industrial average would find that his holdings buy fewer ounces of gold than they did at the beginning of the year. Investors must remember that nominal returns are unimportant; it is the purchasing power of those returns that matter. It makes no difference if the Dow goes up 100% and the dollar is down 50%: the net result is that you have gained nothing. To believe that monetary stimulus from the Fed provides a panacea for the markets is to be ignorant of history. Monetary inflation has always led to mal-investment and financial stress. There exists no method of safely removing the excess liquidity once it is provided. Attempts at removing liquidity have always led to a recession. However, the severity of the recession increases as each opportunity to bring the markets into reconciliation gets postponed. My clients will continue to own inflation-protected assets in order to thrive in this environment of monetary excesses. However, these gains come at the expense of those who are unable to extricate themselves from the quicksand of a falling currency. And it is for them that I weep. *NOTE: I also discuss inflation as a guest in the final segment of this week's edition of the Market Neutral podcast. Click the link to listen! Dec 16, 2007 *Tired of paying fees while your account value plummets? Learn about our new performance-based pricing. Michael Pento 321gold Ltd |
