RAISE INTEREST RATES OR BEAR THE CONSEQUENCES

It is time for the Federal Reserve and the central banks of many other countries with surpluses to tighten interest rates. This is not happening, and the longer it takes for it to happen, the more inflation the world will have to endure. We know why the U.S. and Europe are not tightening rates, but I do not know why many other countries which have had their currencies tied to the dollar (and the U.S. interest rate regime) are not breaking the ties and raising rates…if only for their own benefit.

When the U.S. and countries tied to the U.S. dollar allow their money supplies to grow rapidly (which has been going on for the seven years since 2001) it creates inflation.

In 2001, the Federal Reserve began lowering rates dramatically, trying to come out of the recession. They continued to lower them for years. While the seven years of inflated money supply growth in this current decade is less than the twenty years of inflated money supply growth during the 1960’s and 1970’s (which led to a very large inflation problem in the late 1970’s), it is still not good…not by any measure.

DELEVERAGING IS NOT SHRINKING LIQUIDITY

Now, the U.S. and Europe are in a banking crisis and going through a deleveraging of their banking systems. Please do not confuse deleveraging with shrinking liquidity. Liquidity is still growing even though the banking system has been de leveraging. We get questions all the time like “If banks are failing and deleveraging, how can the money supply be growing?”

Because the Federal Reserve is lending to the banking system, this grows the Fed’s balance sheet, thus creating liquidity. With all of the bank bailouts going on, and with the Fed making credit available against many kinds of collateral, we would not be surprised to see the money supply growth continue for some time. The Fed’s balance sheet shows that Reserve Bank Credit has increased at a 14.4% rate in the past 3 months. The exact same thing is going on in Europe and in the United Kingdom. A review of the Central Bank balance sheets of other growing countries (and of those countries who have adopted a currency pegged to the U.S. dollar and the U.S. interest rate structure) shows further big increases in money growth.

THE CHAIN OF EVENTS

1. Central banks began to inflate 7 years ago.

2. Oil, base metal, gold and food commodity prices went up because of the money supply growth and because of imbedded demand for infrastructure building from countries wanting to grow, improve the standard of living of their populations, and better feed their people. We saw this coming, so we invested in commodity and gold related investments.

3. As a result of the higher commodity prices, we saw a small supply response in some areas. For example, more base metals mines have been built, so the supply of some base metals has increased or will increase somewhat. More grain land will be put into production and more fertilizers will be used in coming years to capture high grain prices…so grain prices may level off at this higher plateau. However, oil is a different case, despite best efforts to find more oil, production falls every year. Gold is another issue that we will discuss later.

4. By now, inflation and inflationary expectations are becoming embedded in the economic system in the U.S. and in many other countries. Even though the inflation data should start to moderate, the inflation problem is far from solved. Commodities have been under selling pressure in recent weeks, but they remain a very good way to hedge against inflation, so we expect them to recover after the current decline.

5. Now is the time to raise interest rates. Because banks are weak and deleveraging, the U.S. and Europe are not going to raise interest rates. Instead, the U.S. and Europe are doing the opposite…supplying more liquidity. Liquidity will continue to be supplied to help keep financial institutions solvent in the U.S. and Europe. Japan, China, India, and many other countries are more able to raise their interest rates…and they should do so now.

6. Currently, there are many voices and many views…some are short sighted, some are statesman-like. Short sighted trade advocates and politicians want to keep rates low and the currency down so they can export more or garner more votes. Statesmen are willing to raises rates and take the anger of the public and short sighted groups, because they realize that in the long run, slower economic growth is preferable to a period of high inflation.

UNFORTUNATELY, STATESMEN ARE IN NOTORIOUSLY SHORT SUPPLY AT THIS JUNCTURE IN HISTORY…SO, INFLATION WILL CONTINUE. IT WILL EBB AND FLOW…BUT IT WILL CONTINUE TO PLAGUE US.

The length of time that it plagues us will depend upon how long we wait to raise interest rates and cut it off. We predict that inflation will continue, but that it will shift from energy, food, and other commodities (where it has been focused thus far) to a more generalized inflation showing up in goods and services. The increased liquidity and the higher commodity and raw material prices are bound to filter into goods and services.

In listening to financial TV, we are struck by the number of supposedly wise advisers who naively think that inflation will disappear just because oil prices are declining. They will be in for an unfortunate awakening to the facts.

GOLD

Earlier in this letter, we mentioned that we would touch more on the subject of gold, so here it is. Gold is not a commodity like food, energy, base metals, or other raw materials needed for infrastructure building. It is a currency substitute. When people believe that their currency is being mismanaged, that there is a tolerance for high inflation in their country, or there is the possibility of a big deflation, they turn to gold as a substitute for a depreciating currency. Also, as developing nations’ populations get wealthier, demand for gold increases as a method to store wealth.

Gold has been an effective mechanism of storing wealth, preserving buying power, and dealing with governmental foolishness for millennia…It will remain so.

All this talk has been a bit depressing. Let us end on an upbeat note. We wish you an enjoyable end to your summer season north of the Equator, and a welcoming of spring to our readers in the southern hemisphere.

Thanks for listening.