“I do not under any circumstance favor raising the price of gold. It would perpetuate that “barbarous metal” in international monetary use. We have quite rightly broken the link between gold and our domestic money. We should also break the link between gold and international money. The supply of money, neither domestic nor international, should not be dependent over the long run on the accidents of supply and demand in the marketplace for just one commodity.” July 12, 1968 – Darryl R. Francis, President of the Reserve Bank of St. Louis. 1. And so it came to pass not long after the speech by Mr. Francis that in August 1971 US President Richard Nixon unilaterally broke the US$/gold peg and declared the US$ no longer convertible to gold. The convertibility of US$’s to gold was the last tenuous link between fiat currencies pegged to the US$ and gold. I pick up the tale of Gold and Fiat Money in January 1971 and will tell this tale with graphs. Graphs of fiat money; of consumer inflations and asset inflations; interest rates; central bank activities; gold prices; and official gold movements.
Placing the fiat money year of 1971 in the context of gold requires a pit stop at inflation. Often we are lulled into a sense of security by looking at the inflation rate. This time perhaps we should first look at the traditional inflation index, the CPI.
1971 certainly looks like an important point in consumer inflation history. The index chart is revealing but the traditional inflation rate chart is also required to complete the picture.
The inflation rate was 5.3% in January 1971 and after an initial decline, it increased to peak at 14.4% in May 1980. The actual index data is much more telling than the annual rate of change data.
Consumer inflation is but one facet of inflation. A less obvious inflation is asset inflation. There are no official statistics to extract asset inflations and no consensus measurement of an asset inflation index. The DJIA will be used as a proxy for asset inflation in this analysis.
Gold and the managers of fiat money.Gold has always been the unofficial informant on inflation activity. A precious metal much maligned and feverishly coveted. It is said that it has no purpose and no industrial application. Snide comments about a barbaric metal ruling human emotions are common. What about the role played by gold in human relationships? Relationships between men and women, lovers, friends and family? What about the gifts of jewelry, of dowry or of inheritance?
Gold has always been a store of value in the history of mankind and still is, despite 1971. In 2010 the gold price confirms that gold as a monetary metal is still the ultimate go-to store of value in times of trouble. Mr. Francis, in the same speech as quoted from above, warned in 1968 that the then international trade and currency crisis may cause a “run on gold”. In 2010 we look back upon the gold price rise since 2000 and again contemplate a run on gold.
The largest concentrations of holdings of this scarce metal, of which the total above ground stock will only make up a cube of less than 20 cubic meters, are still held officially by Sovereigns and International Institutions (IMF, BIS, EPU/EF, EMI and others). The World Gold Council has kept a record from 1948 of the Gold Reserves of Major Official Gold Holders. They held 29,727 tons of gold at the end of 2008, down from a peak of 38,347 tons in 1965. My generous guess of the US$ value of Official Gold Reserves in July 2010 would be about $1.167 trillion (30,000 tons * 32,151 troy oz * $1210).
We can take a picture of the interaction between the $ gold price and the managers of fiat money since 1971 by observing the activity of the Major Official Gold Holders. Did they buy or did they sell?
For now we just gather the components and observe the dynamics. Observe a first phase of official selling activity from 1971 to 1980. Note a second phase of official selling; slow at first from about the middle of the eighties but accelerating into 2006 and easing off since then. Both phases climaxed in a dichotomy of high official sales and a parabolic rise in gold price.
The moves in Official Gold Reserves are a good proxy for gold movement between the “Global Public Sector” and the “Global Private Sector”. The inclusion of International Institutions with the Global Public Sector will avoid the distraction of interactions and gold movements between Sovereigns and International Institutions.
The chart is clear, the Official Holders have sold gold reserves sine 1971 and have been growing total sovereign reserves by buying each other’s sovereign debt rather than increase gold holdings. Gold is nobody’s debt, safe from default. Exchanging fiat money debt for the reality of gold, the plenty for the scarce, an ever increasing promise to pay for a historic store of value will for now remain a logical and philosophical puzzle.
The global Official Foreign Exchange Reserves ratio to the Global Official Gold Reserves valued in US$ has increased from 3.2 to 1 in 1995 to a staggering 10 to 1 in 2008. The increase in currency reserves happened in spite of a doubling of the annual gold price from 1995 to 2008.
Interest rates.Interest rates feature prominently in any analyses of fiat money and of gold. Gold pays no interest but is claimed to be a better store of value than fiat money, a claim supported by the inflation indexes. The inflation index has shown what happened to fiat money but what about the influence of interest rates?
The Federal Funds Rate will be the proxy for short term rates and the 10 year Treasury Rate (constant maturity) will be the proxy for long term rates.
Here a dominance of the short term rate higher than the long term rate can be observed for the period 1971 to 1981. The short term rate dominates to the downside from the long term rate from 1982 to 2010. The Federal Funds Rate for the two distinct phases was 4.14% in 1971 raising to peak at 19.1% in June 1981 and falling from there to a low of 0.11% in January 2010.
USA Central Bank (Board of the Federal Reserve System) activity.The on balance sheet fiat money activity of the central bank requires scrutiny.
The first variable is the Currency in Circulation. It grows from $56 billion in January 1971 to $ 941 billion by June 2010. In the context of gold compare the growth in Currency in Circulation with the value of the Global Official Gold Reserves.
The next variable for scrutiny is the Reserve Balances with Federal Reserve Banks from the banking sector. It has a history of almost no significance other than diminishing to mostly below $10 billion by August 2008 when suddenly it gains a significant new prominence.
These two major footprints explain the origin of the liabilities of the central bank, where it gets its balance sheet liquidity from. The near trillion dollar growth in Currency in Circulation (interest free) for the period January 1971 to June 2010 is significant but the explosion in Reserve Balances by $1,02 trillion from August 2008 to June 2010 will require explanation.
Some of the answer lies with the asset side of the balance sheet of the central bank.
The Reserve Bank Credit series defines the asset side of the balance sheet and is described by the Board of the Federal Reserve (the Fed) as:
“Reserve Bank credit is the sum of securities held outright, repurchase agreements, term auction credit, other loans, net portfolio holdings of Commercial Paper Funding Facility LLC, net portfolio holdings of LLCs funded through the Money Market Investor Funding Facility, net portfolio holdings of Maiden Lane LLC, net portfolio holdings of Maiden Lane II LLC, net portfolio holdings of Maiden Lane III LLC, float, central bank liquidity swaps, and other Federal Reserve assets.”It includes all the facilities and programs implemented by the Fed in acting as the central bank for the banks and as manager of the sales of central government debt including all the emergency measures taken since August 2008. The emergency facilities fill the gap between August 2008 and late November 2008 to January 2009 when purchases of mortgage backed securities were announced and implemented.
The dominant asset component in the Reserve Bank Credit variable is that of Securities Held Outright.
The securities held by the Fed prior to August 2008 were predominantly Public Sector securities. Since introducing emergency measures in response to the Global Financial Crises in August 2008 the mix has changed and the “Securities Held Outright” series is currently defined as:
“The amount of securities held by Federal Reserve Banks. This quantity is the cumulative result of permanent open market operations: outright purchases or sales of securities, conducted by the Federal Reserve. Section 14 of the Federal Reserve Act defines the securities that the Federal Reserve is authorized to buy and sell.”Mortgage-backed securities as part of Securities Held Outright amounted to $1.119 trillion as at 30 June 2010 and are described as:
“On November 25, 2008, the Federal Reserve announced a program to purchase mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae. The goal of the program is to provide support to mortgage and housing markets and to foster improved conditions in financial markets. Purchases of these securities began on January 5, 2009.
Additional information on System transactions in mortgage-backed securities is available at www.newyorkfed.org/markets/mbs/.” These numbers are important for it shows that the Reserve Balances of the banking sector as a liability of the Fed is near matched with the investment in mortgage backed securities. The monetary activity of venturing into mortgage-backed securities has been sterilized by the growth in the Reserve Balances of the banking sector. Here it is important to understand that the mortgage-backed facility quarantines what would have been a deflationary implosion of the housing bubble (a major debt inflated asset bubble). The Reserve Balances cannot be released into the banking sector while the Fed is invested in mortgage-backed securities without unleashing significant inflation risks. The interest received on the mortgage-backed securities will finance the interest payable by the Fed on the Reserve Balances of the banks.
The activities of monetary authorities as expressed in the assets and liabilities can be summarized in the Reserve Bank Credit series (asset side of the balance sheet) or in the Sum of Currency in Circulation & Reserve Balances (liabilities of the Fed).
The mortgage-backed facility of the Fed is close to full utilization at $1.25 trillion.
The central bank is active in providing liquidity to the banking sector. This activity is behind the achievement of the targeted Federal Funds Rate. Rapid debt formation is the result of stimulatory central bank liquidity provision.
The decline in Household Debt in the presence of historically low interest rates and easy access to liquidity is indicative of debt saturation (see War on Savings available on my blog at
http://sareloberholster.blogspot.com/).
Government stepped up Public Debt formation when Household Debt started to collapse.
Liquidity provision also spilled over into the rest of the economy and gave rise to investor facilitation of additional debt formation beyond the banking sector. The chart of Commercial Paper outstanding will be the proxy for this development. The housing bubble and mortgage-backed securities supply accounts for most of the growth from 2004 to 2007 and for most of the decline from 2007 to 2010.
Inflations and the gold price.How did the gold price perform against the inflation indexes?
The sales activities of the Major Official Holders of gold help to explain the delays in the gold price response to inflations. The relative importance of gold over time as a commodity and as a monetary metal is visible in the gold price. See for example the decline in gold price prior to the decline in the PPI in 2008/09 which raises a question, how did the gold price anticipate the decline in the PPI? The rise in gold price since 2008, given the information presented in these charts, certainly seems monetary in origin.
The relationships are not constant but the influences are visible. Stock exchanges are a popular asset class for asset inflation. Observe the interaction between the traditional inflations and the DJIA as a proxy for asset inflation.
The period from 1971 to 1981 saw significant inflation in both PPI and CPI but no DJIA asset inflation is evident. The rising and high interest rates during this period probably caused the muted asset inflation response but it requires a chart of its own. The DJIA shows significant asset inflation rising from 875 on monthly data in December 1981 to 11,497 in December 1999. Then came the period of instability from 2000 to 2010. First the Tech crash of 2000 to 2003, followed by the housing bubble pick-me-up into late 2007, together with the global economic crises and finally (for now) the rebound out of March 2009.
How did the gold price interact with the DJIA as asset inflation proxy?
The gold price responded to the inflations of the CPI and the PPI in the 1971 to 1981 period when DJIA asset inflation was absent but failed to respond to the intense initial asset inflation period of the DJIA. The gold price only took off with the arrival of the period of instability.
Interest Rates and Inflations.The presentation of the asset inflation proxy and interest rates in one chart provides valuable insights.
The rising interest rate phase from 1971 to 1981 kept asset inflation at bay but the declining phase from the Federal Funds Rate of 19.1% to around 3% in 1993/94 set the stage for significant asset inflation. Observe also the more stable decline in the long term rate. Interest rates of around 5% and generally declining, on observation, point to strong asset inflation. The invest-with-debt characteristic so evident during the housing bubble may be behind this phenomenon. The asset inflation in the period 2001 to 2010 required additional declines in interest rates to prevent asset deflation. These interventions drove interest rates to near zero while attempting to maintain the asset inflations.
The gold price did not respond in the same manner as asset inflations did towards interest rates.
Note how the gold price rose into a parabolic spike together with interest rates in the period 1971 to 1980. It then declined with interest rates into 2001 just to break away in contradiction, into another parabolic rise but this time with interest rates declining into the absurdity of the zero bound. The gold price responded to factors which had an impact on interest rates but the gold price and interest rates seem to have little in common. This is significant since gold responded to traditional inflations and since 2001 also to asset inflation. Interest rates may have a connection with the rate of change of the inflation index but the actual performance of inflation indexes and asset inflations are not well correlated with interest rates. This statement is consistent with an economy where the interest rate is decided by the managers of fiat money and not established with price discovery in the markets.
The Gold price as a whistleblower on inflation is warning that the cumulative effects of traditional and asset inflations on the gold price in the era of fiat money can no longer be contained by official gold sales. In 2010 as in 1968, again there is global debate with reference to international currency instabilities and international trade structural stress due to merchantalistic currency practices by export orientated countries.
The declining trend in Federal Funds Rate from 2001 to the present is no longer consistent with the movements in the inflation indexes, particularly with asset inflations for the same period. The gold price has decided to side with risk and inflation given this altered state between interest rates and all the inflations.
Multiple Variable Charts 
Summary of Observations.1. Inflation is not as muted as indicated by the consumer inflation rate when viewed form the perspective of the PPI, CPI and asset inflations.
2. Official gold sales have been depressing the Gold Price since 1971 yet failed to contain the 2001/2 to 2010 strong advance in the gold price.
3. Lowering interest rates into the zero bound has contributed significantly to the creation of asset inflations and the zero bound is now a necessity in preventing further collapse of the asset inflations.
4. Balance sheet expansion, lowering interest rates and liquidity provisions by the central bank had facilitated parabolic debt expansions which have lately become unsustainable even with unrestrained liquidity provision and near zero interest rates.
5. Quarantining the housing bubble and sterilizing the potential liquidity spill into the economy have trapped the central bank in stasis between the powerful forces of hyperinflation and deflation.
6. A rising gold price is responding to economic risk generally, store of value risks particularly that of fiat money, economic structural instability and the risk of hyperinflationary events in currencies.
7. Household debt formation and private securities debt markets have turned negative while already high US government debt is rising in a new parabolic spike.
8. Default risk on Sovereign Debt and a rising gold price have restrained gold sales by Major Official Holders of gold reserves since 2006 and may well turn around a philosophy of official selling which have prevailed since 1965.
9. The spike in the gold price since 2009 coincides with the purchase of mortgage-backed securities by the Fed as the main component in placing the housing asset inflation in quarantine.
10. The period from 2007 to mid 2010 is typified by extreme PPI changes, gold price movements, stock exchange movements, central bank balance sheet activity, interest rate adjustments and debt formation activity. Nothing in the charts can be interpreted as economic harmony while extreme volatility writes “risk” in neon letters.
The tale in the charts from the dawn of irredeemable fiat money to a dusk of economic structural distortions is but a footnote in the economic history of gold.
Sarel Oberholster
BCom (Cum Laude), CAIB (SA).
14 July 2010
Please email me at
ccpt@iafrica.com with any comments. More links and essays can be found on my blog at
http://sareloberholster.blogspot.com/ .
© Sarel Oberholster
Reference:
1. Francis, Darryl R, (1968),
The Balance of Payments, The Dollar and Gold, Speech at a Rotary Inter City meeting Webster Groves, YMCA, p 13, published by the Federal Reserve Bank of St Louis at
http://fraser.stlouisfed.org/historicaldocs/DRF68/download/38004/Francis_19680712.pdf .
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