The Outlook for the Dollar Worsens

August 14, 2006 – The Federal Reserve has stopped raising interest rates. Therefore, the logical question to ask ourselves is whether their decision has changed anything. I think it has.

While the Fed was raising interest rates, one could reasonably argue that its aim was to fight inflation, which continues to climb. In the 12 months ending June 30, 2005, the Consumer Price Index rose 2.5%. However, in the 12 months ending June 30, 2006, the CPI rose 4.6%. This comparison shows that even by the governments own calculation, which I believe understates the true rate of inflation, it is clear that inflation is a growing problem.

So now that the Fed has stopped – at least for now – raising rates, it seems clear that they are focusing on something other than inflation. The object of their redirected attention is clear. The Fed has become focused on the economy.

With the slump in housing becoming obvious, coupled with $70+ crude oil imposing a onerous burden throughout the country, the economy is slumping. So the Fed has changed its priorities. Instead of fighting inflation, the Fed instead is now trying to avoid a recession.

The implications for the US dollar are ominous. The Fed and Treasury Secretary Paulson can try intervention to mop up surplus dollars from central banks and others who are choosing to reduce their dollar balances. They can also try talking up the dollar. But it is not ‘talk’ that the dollar needs. It needs purposeful action, like raising interest rates to make the dollar more attractive when compared to other currencies. It is therefore noteworthy that the European Central Bank and the Bank of England raised their interest rate this month while the Fed sat on its hands. It is also noteworthy that gold and silver continue to hold up as well as they have.

A year ago gold was $442, and silver was $6.95. From those prices both precious metals began to rally and continued to climb higher for nine months. Then after making multi-decades highs in May, both gold and silver began a correction, which continues. So even though gold is 12% below its high, while silver is down 20%, the bigger picture tells us a different and more important story. Namely, over the past twelve months gold and silver have risen 43% and 70% respectively.

Given the shift in focus by the Fed from fighting inflation to avoiding a recession, more gains for gold and silver are likely. So view the current correction from a different perspective. This correction is a good buying opportunity.

Look across the valley. Look at the problems debasing the dollar, from rising federal government debt to central banks diversifying out of the dollar (the Bank of Italy being the latest in a long list of central banks taking that course of action). Then consider the implications of a Fed focused on avoiding a recession instead of preserving the purchasing power of the dollar. It won’t take long to recognize that the dollar’s exchange rate will head lower and inflation will worsen.

Gold and silver are the best way to protect oneself from today’s growing inflation, and the worsening inflation already ‘baked into the cake’.

In the Monday, August 7, 2006 issue of Barron’s I was asked about my gold outlook. I replied: “It’s going up because of growing inflationary expectations and rapid money-supply growth.” I was then asked whether gold should be bought now or to wait for the correction to dig deeper. My response was: “If I’m right and we’re going to $850 and eventually four digits, does it matter whether you buy at $620 or $630?“

Therefore, view the current correction in gold and silver as a buying opportunity. Given that the correction is three months old and the Fed is now on ‘hold’, it seems likely that this current buying opportunity won’t last much longer.