Catch-22 for the Fed

2011-JUN-04

In the last week there have been a raft of statistics showing that the US economy is weakening. The implications for other western economies are hardly bullish. They also strengthen arguments in favour of more reflation for fear of something worse. This is despite further increases in the US monetary base to a record $2.5 trillion. It is easy to forget that less than three years ago, when the economy was surfing on a fading credit bubble, the monetary base stood at a record $820 billion, so it has increased by over 300% since then. Compare this with the 44% rise over the preceding seven years. With such a substantial debasement of money it must be worrying to the authorities that there has been little discernible economic benefit.

The simple reason is that the banks have increased their reserves at the Fed, rather than lending them out to the private sector. This is reflected in non-borrowed reserves, which have increased from virtually nothing to nearly $2.5 trillion. It is because the money is sitting in the Fed that price inflation is not yet totally out of control, but inflation has the potential to become a very serious problem.

Putting this issue to one side for a moment, the Fed has to consider its actions in the coming months, taking into account the end of the stimulus from QE2 and the political deadlock over raising the debt limit. As regards the latter, the federal government is now running on empty, and its central bank is severely restricted in what it can do to help.

We will never know for certain if the Mexican central bank anticipated the Fed’s problem before deciding to buy 100 tonnes of gold, but for a NAFTA member to publicly break ranks and buy gold is quite a step. And for it to do this in a rising market is doubly interesting, because the vast bulk of the purchase was done before the April correction. It is also a clear signal that the cartel controlling the Bank for International Settlements is losing influence.

It is the Fed’s problem, rather than Greece’s impending financial collapse, that should be closely monitored by gold bugs. This is not to belittle European difficulties and those of the European Central Bank. But in a strict monetary sense, the ECB is not so far down the monetary inflation route as the Fed – yet. It is the Fed which has already expanded its money-quantity explosively, and is struggling to find further monetary fuel to lift the economy. It is the Fed that is locked on a course of accelerating monetary inflation, as those monetary base statistics show.

There is little doubt that the Fed will try to find some way to create more money while funding the deficit; we don’t yet know how. Even if this is achieved without all those non-borrowed reserves flooding into the economy, the risk escalates of a sudden loss of confidence in paper dollars. Both Keynesians and monetarists forming policy seem oblivious to the increasing possibility of a tipping-point being reached, where the dollar’s fall suddenly accelerates.

So whatever the true reason for the Mexican purchases of gold, it is an eminently sensible risk diversification out of dollars. Other central banks will surely have taken note.