Federal Reserve Jawboning Illustrated

October 17, 2005 – For months formidable forces of inflation and other forms of monetary debasement have been gathering at a frightening pace. Rising energy prices, out-of-control federal spending, and a growing mountain of debt are just some of the more visible problems. So how does the Federal Reserve – the guardian of the US dollar – respond to this threat? Not to worry. We have been told that the Federal Reserve will continue to raise interest rates at a “measured pace”. It is really silly that so many commentators have been making a big deal of this inane statement. Would the Fed actually come out and say anything else? Would it be honest with the American people and say that the threat of inflation is not only real, but also growing? Would the Fed ever state that it is going to raise interest rates at a ‘rapid pace’ in order to prevent more inflation?

Of course not, but in reality that is what the Federal Reserve should be doing. It should be raising interest rates at a ‘rapid pace’ if it intends to seriously conquer today’s monetary problems and save the dollar from a total collapse. ‘Bubbles’ Greenspan should be taking some directions from Paul Volcker, who raised interest rates at a ‘rapid pace’ after he was appointed chairman of the Federal Reserve in 1979.

Volcker understood that meaningful actions were necessary to save the dollar from a total inflationary collapse. So he did what he had to do. He raised dollar interest rates at a rapid pace because he understood that only high interest rates would save the dollar. Look at it this way.

Consumers have a choice – hold dollars (which is just some intangible promise) or hold gold (which is a real and tangible asset). Gold is money that is not contingent upon some bank or Fed chairman promise. But consequently, the trade-off is that you do not earn any interest on your gold because you are not taking the risk of someone’s promise.

So when monetary problems grow, consumers choose to increasingly opt out of a troubled dollar and convert their purchasing power into the safety and security of gold. Importantly, once this trend to move out from the dollar starts, it is hard to stop, as Volcker found out.

He used the only tool available to him to re-establish confidence in the dollar. He started raising interest rates as soon as he assumed office and kept on raising them. He needed to get people to move out from their gold and back into dollars, and he knew the only way to do this (without imposing capital controls, which I continue to expect are coming soon to the US) was to raise dollar interest rates high enough in order to entice – i.e., essentially bribe consumers back into the dollar.

Volcker kept raising interest rates until they were much higher than the rate of inflation. In other words, real dollar interest rates (i.e., dollar interest rates less the rate of inflation) soared to record highs – levels that had been unimaginable only a few years before.

The record high interest rates did the job intended for them. They enticed a lot of people out of gold and other tangible assets, and moved them back into dollars so they could earn the high interest rates Volcker created. But Alan Greenspan is not doing this. I’ll use the accompanying chart to explain this point.

This chart presents real dollar interest rates and the gold price. Real interest rates can be calculated in a number of ways, but I subtract the inflation rate (I use the CPI as a proxy for the inflation rate) from the federal funds rate (which is the rate at which banks lend and borrow money for short-term needs). If the difference is positive, dollar holders are earning a rate of return greater than the rate of inflation (i.e., their purchasing power is increasing). Conversely, their purchasing power is decreasing if real dollar interest rates are negative because in this case, inflation more than erodes what dollar holders gain from any interest they earn from their dollars. Given this brief explanation, take a look at the chart above.

Generally speaking, a positive return is necessary to keep consumers in dollars. In other words, to entice consumers to hold dollars and avoid gold, real dollar interest rates should be positive. When real rates are negative, the gold price soars, as consumers flee the dollar and demand gold instead. Look at what happened in the 1970’s for example.

Conversely, when real dollar interest rates soar, as they did under Volcker, the price of gold falls. Look at what happened in the early 1980’s. It was the unprecedented climb in real interest rates that stopped gold’s meteoric advance back then.

Since the late 1990’s real rates have been falling. What’s more, real rates have been negative for a couple of years, so it is any surprise that the gold price is rising? Of course not.

Consumers are not dumb. They look through the nonsense of the “core” CPI, and they don’t listen to the mindless jawboning from the Federal Reserve. Consumers can see that the Fed is way behind the curve because real interest rates are negative. Consequently, they understand that one is better off owning gold, and will continue to be better off until the Fed chairman does what Volcker did – raise dollar interest rates at a ‘rapid pace’. Will it happen?

No, it won’t, and the reason is simple. The US cannot afford to pay the bill of high real interest rates.

When Volcker became Fed chairman, the US was the largest creditor nation in the world. There was no mountain of debt, no derivatives bubble, no stock market bubble, and the US savings rate was positive. What’s more the federal government’s budget deficit was relatively tame compared to the big spending under the Bush administration, and the US was not fighting any foreign war – it was the Soviets who were bogged down in Afghanistan.

Today’s circumstances are the exact opposite. So neither ‘Bubbles’ Greenspan nor his soon to be appointed successor can raise interest rates to the achieve positive real interest rates that Volcker needed to save the dollar. If it were tried, the Fed would destroy what remains of US economic activity. The growing interest expense burden would sink the federal government’s ability to maintain the illusion that it is solvent and can repay its debts. In other words, raising interest rates today like Volcker did would sink the economy and the dollar along with it. So ‘Bubbles’ Greenspan is left to using the only tool available to him, namely, jawboning, which is the politically correct term for propaganda. There is of course another tool – capital controls. They will come when jawboning no longer does the job, which means soon – possibly as early as next year.

In the recent past, I have been warning that severe and intractable problems with the dollar were brewing, but we have now passed that early development stage. The problems for the dollar are becoming increasingly visible. For example, the huge surge in the Consumer Price Index reported this past Friday was the largest increase in 25 years.

If it weren’t so tragic, it would be laughable that the propaganda artists of the vested interests running the Wall Street-to-Washington axis continue to focus on the so-called “core rate” of inflation, disingenuously calculated to exclude necessities of life like food and energy costs. But let them play their artful dodges of the truth. It no longer matters. They are speaking to a diminishing audience. What’s more, their propaganda is becoming even less credible to the faithful who believe that their government and its captive central bank is telling them the truth.

Remember, action always speaks louder than words, and the slow pace at which the Fed is raising interest rates means that inflation will become a growing problem. It also means that gold will continue to climb higher.