FEDging the figures

Alasdair Macleod – 28 January 2012

Both the US Federal Reserve and the European Central Bank are now offering limitless quantities of new money – the ECB to support the banks, and the Fed for reasons (despite explanations) that are not entirely clear. The Fed in its press release announced that it expected interest rates to “warrant exceptionally low levels for the Federal Funds Rate at least through late 2014.” The fact that the central banks governing the two most important currencies in the world are issuing money to all-comers at very little interest cost for up three years has not been lost on gold and silver, whose prices shot up in response to the Fed’s announcement.

The Fed has effectively extended its zero interest rate policy (ZIRP) for another 18 months. The reason stated is “low rates of resource utilisation and a subdued outlook for inflation in the medium run”. More important perhaps and unsaid is the presidential election due later this year and the need to finance a deficit that seems impossible to cut.

The Fed is running huge risks with its extended ZIRP, principally with monetary inflation morphing into price inflation. To help achieve its low inflation target the Fed uses the Personal Consumption Expenditures Price Index (PCEPI), which assumes that consumers switch spending from higher priced goods to those that are stable or falling. The result is that this index rises at about one-third less than the Consumer Price Index, which itself rises at less than half the CPI calculated on the more honest methodology used before 1980. The upshot is that the Fed uses inflation targets that are so heavily adjusted that they are effectively meaningless.

To the Keynesians at the Fed, subdued inflation is linked with a sluggish economy, and here the Fed is very selective in its approach. It admits that employment is picking up, and household spending “continues to advance”; but instead chooses to worry over slowing fixed investment and a depressed housing sector. Surely, whatever your views, there are enough signs of economic stabilisation to justify sitting on the fence, instead of committing to ZIRP for an extra 18 months.

I take the view that Gross Domestic Product is likely to surprise on the upside, as I wrote in an article on 10 January. In that article I gave concrete reasons why, and suggested that money will begin to flow from capital markets into the economy. This is important, because GDP is only a money quantity and can rise without any underlying economic progression – the difference being reflected in the prices of goods and services. So GDP can actually rise with no underlying improvement in economic activity, it merely reflecting higher prices.

Changes in the prices of goods and services are actually impossible to measure and so cannot be quantified. Under-reporting price increases by using an index approximation such as the GDP deflator, which represents price inflation similarly to the PCEPI, artificially inflates real GDP. It will be interesting to hear what excuse the Fed comes up with then for the continuing for even longer with ZIRP. The reality is that the Fed and other central bankers are cornered and have only one tool left: issue as much paper money as it takes to prevent systemic financial calamity. This realisation is only just dawning on individuals with savings to protect, which is why precious metals were right to rise so sharply.

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Alasdair started his career as a stockbroker in 1970 on the London Stock Exchange. In those days, trainees learned everything: from making the tea, to corporate finance, to evaluating and dealing in equities and bonds. They learned rapidly through experience about things as diverse as mining shares and general economics. It was excellent training, and within nine years Alasdair had risen to become senior partner of his firm. Subsequently, Alasdair held positions at director level in investment management, and worked as a mutual fund manager. He also worked at a bank in Guernsey as an executive director. For most of his 40 years in the finance industry, Alasdair has been de-mystifying macro-economic events for his investing clients. The accumulation of this experience has convinced him that unsound monetary policies are the most destructive weapon governments use against the common man. Accordingly, his mission is to educate and inform the public in layman’s terms what governments do with money and how to protect themselves from the consequences.

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