There is quite a bit of chatter this morning about downward pressure on the price of gold. Goldman Sachs is forecasting the price to fall below $1,000, and some talking heads on CNBC were talking about gold hitting $600.
Most of the rationale focuses on the Federal Reserve and the reduction of Quantitative Easing (QE3). The implication is that “tapering” the rate of money printing is going to somehow reduce the size of the Fed’s balance sheet, which has been bloated by about $3 trillion with Treasuries and mortgage bonds acquired during the Grand Monetary Experiment.
Even if the Fed “tapers” it is still adding significantly to the size of its balance sheet. If the Fed “tapers” QE3 all the way to zero, the balance sheet might stabilize at that point, but if we are talking a year from now, there will be about $4 trillion.
Gold is not a bet that QE will go on forever, which is what a lot of the commentators this morning are trying to argue.
Gold is a bet that the Fed will never find the will to reduce the size of its balance sheet back to normal.
Here is why a perpetually bloated Fed balance sheet is a problem:
If there is $4 trillion worth of bonds when the Fed finishes “tapering” QE3 all the way to zero, there will be at least $20 trillion of inflationary power in the U.S. banking system looking for a spark. Most of the cash that the Fed prints to buy the bonds becomes “excess reserves” in the banks. Banks have not been lending money at the rate that they have traditionally because they are not overly confident. But, if they become more confident (perhaps in conjunction with more robust economic growth and employment) they will start to lend that money out. Under the Fractional Reserve banking system, only 10% of the capital has to be kept at the banks. As a result, on excess reserves of $4 trillion, the banks can potentially lend out about $36 trillion in the most aggressive scenario. But let’s say they are conservative and only expand lending by about $20 trillion. Well, the total money supply is currently only $16 trillion. It would become $36 trillion under this relatively conservative scenario. That’s a tremendous amount of money growth and considerable devaluation in a relatively short period of time. That’s what gold is potentially protecting against.
As a result, this morning’s prognosticators discussing the downside of gold need to explain how the Fed is going to “exit”, not how the Fed is going to “taper.” Unfortunately for their argument, Ben Bernanke quietly discarded his Exit Plan in April 2009, five and a half years ago. Without that, the argument for lower gold based on current Fed policy is just hopeful rhetoric for the gold bears and shorts.
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