Implications of the grain of respect that we have for the Federal Reserve…

Behold, after a near-tripling in the total size of the Fed’s balance sheet over just three years, it seems that the monopoly producers of the world’s base currency have finally decided to act in a pseudo-responsible fashion. Although the Fed continues the reality-denying folly of attempting to fix prices in the realm of the production of IOU claims upon central bank notes (ZIRP), at least it’s trying to cease the outright monetary debasement that we’ve all become accustomed to (i.e. central bank balance sheet expansions). Here I outline the implications of a nominally ‘responsible’ (ahem!) Federal Reserve and outline our thoughts on the manner in which the inevitable U-turn back to monetary profligacy might come to pass.

 

Courtesy of their deep involvement with the state, the actions of central banks are driven by the allure of popularity rather than the arduous (but sane) effort of entrepreneurial calculation. Instead of striving for high and consistent long-term profits, central bankers engage in activities that tend to invite the greatest respect from the supposedly ‘intellectually superior’ strata of society over the long-term (inverted commas used because said usage is intended to denote the consensus rather than truth). As can be seen on the chart below, this method has resulted in policies that all point one way: — towards chronic monetary dilution.

 

Total Size of the Fed's Balance Sheet since 1915

Total Size of the Federal Reserve System's Balance Sheet Since 1915.

 

What’s with this pause in string of balance sheet expansions then? Well it would seem that the Fed has given up on the prospect of inviting the creation of the IOU claims upon Federal Reserve notes (deposits) via the mechanism of monetary debasement. In short, the Fed has found that no matter how vigorously it debauches it’s own liabilities (Federal Reserve Notes & Reserve Balances), it cannot seem to get US commercial banks to commit to more aggressive fractional-reserve banking. Their efforts in the realm of balance sheet expansions have been quite unconvincing apparently — the child in the following video has remained somewhat unconvinced:

 

 

But why now? After all, the previous efforts have been quite illusory. After short and mild periods of relief, stresses upon the market values of existing entrepreneurial structures have swiftly resumed. Indeed, this is quite similar to the pattern seen in France during the French Revolution – as Andrew Dickinson White wrote (while referring to the transient effects of monetary debasement) in Fiat Money Inflation in France:

 

The great majority of Frenchmen now became desperate optimists, declaring that inflation is prosperity. Throughout France there came temporary good feeling. The nation was becoming inebriated with paper money. The good feeling was that of a drunkard just after his draught; and it is to be noted as a simple historical fact, corresponding to a physiological fact, that, as draughts of paper money came faster the successive periods of good feeling grew shorter.

 

Here’s where our sliver of respect for the Fed comes in. They have obviously heard of the great instances enormous inflation, and despite their peculiar theories on these matters, they at least understand (however badly) that the ‘printing of money’ was somehow linked to the ensuing ‘inflation’ (inverted commas used to indicate that the objects to which these words refer are also different for these people). So, their attempt to have their cake and eat it too has turned to promises (ZIRP) rather than promise-less action (simple balance sheet expansions). For us at least, this leaves on crucial question; can they keep the former promise without utilizing the latter action? We are quite sure that they cannot maintain this over a meaningful period of time – either they’ll give up on the promise or they’ll resume central bank balance sheet expansions to maintain it. Either way this is friendly to a Short-Dow / Long-Gold position in one’s portfolio:

 

Dow Gold Ratio Generational Cycle Updated for 23 October 2011

Dow Gold Ratio - Click to enlarge. Source: World Gold Council & Yahoo Finance

 

Dow Gold Ratio Generational Cycle Log Scale

Dow Gold Ratio on a Log Scale - Click to enlarge. Source: Yahoo Finance & World Gold Council

 

There will likely come a time when the Fed will need to choose between abandoning the ZIRP (in favor of a stable Fed balance sheet) or resuming central bank balance sheet expansions (in favor of keeping the promise of a ZIRP). After all, in their ‘intelligent’ eyes — if the banks of the US fall, then the world implodes.

 

Nuclear Explosion - Lest the Banks of the US fail...

Quick! Print! Print! Lest the banks of the US fail.... KAAABOOOOM!!!!!!! (too late)...

 

In the former case, it will likely be the case that gold outperforms equities — as we remain in a delevering cycle (institutions remain heavily dependent on a continuing flow of credit). In the latter case, gold naturally does well against Federal Reserve notes (see here for more about this).

 

For now, however, it seems like the Fed has temporarily convinced its friends that they call all have their cakes and eat them too (or see our newsletter for our more conspiratorial take on this). Taking a look at the ‘true money supply’ figures published by Michael Pollaro of The Contrarian Take – it seems that US commercial banks are in expansion mode:

 

Michael Pollaro's True Money Supply Figures

Michael Pollaro's True Money Supply Figures - Click to enlarge.

 

But we should be wary that even by consensual, mechanistic standards, ‘inflation’ is uncomfortably high:

 

St Louis Fed inflation yoy Change

YoY Change in the CPI - Click to enlarge. Source: St Louis Fed.

 

So, with the Fed’s penchant for a medium of exchange that depreciates against the CPI at a small rate, it may turn out that they feel compelled to abandon ZIRP also. However, again, we would suspect that the legacy debt will assert higher discipline upon the equity capital markets than the gold market (which is positive for the Long-Gold/Short-Dow trade).

 

As can be seen from the following chart of the assets and liabilities of the Federal Reserve System have remained relatively consistent over the past few months.

 

Federal Reserve's Assets as detailed on factors affecting reserve balances statistical release

Assets of the Federal Reserve System - Click to enlarge, Source: Board of Governors of the Federal Reserve System

 

Assets of the Federal Reserve System (presented on a proportional basis) as detailed on the factors affecting reserve balances statistical release

Assets of the Federal Reserve System (presented on a proportional basis) - Click to enlarge. Source: Board of Governors of the Federal Reserve System

 

Liabilities of the Federal Reserve System as detailed on the factors affecting reserve balances statistical release

Liabilities of the Federal Reserve System - Click to enlarge. Source: Board of Governors of the Federal Reserve System

 

Liabilities of the Federal Reserve System (presented on a proportional basis) as detailed in the factors affecting reserve balances statistical release

Liabilities of the Federal Reserve System (presented on a proportional basis) - Click to enlarge. Source: Board of Governors of the Federal Reserve System

See here for our collection of rare historical economic data.

Posted Oct 23, 2011

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