Gold As Inflation Hedge, Or Something Else?

In his latest "Wealthy Boomer" column, Jonathan Chevreau makes the case for holding some of one's wealth in gold to hedge against the beast. In a talk with Nick Barisheff, he learned about the term "hyperstagflation" (which is, by the way, a real term.)

Consumers and investors well know garden-variety inflation and continual rises in the cost of living. Governments tolerate (and arguably create) modest annual inflation rates of 2% to 3%. This seems innocuous, but purchasing power of dollars will steadily erode unless you can generate real returns beyond inflation. With interest rates near historic lows, short-term savings vehicles have negative real returns.

The fear is governments and central banks will fail to maintain a balancing act between mild inflation and economic growth, with runaway inflation morphing into the kind of hyperinflation Weimar Germany experienced in the 1920s or currently afflicts Zimbabwe.

Gold enthusiasts like Mr. Barisheff believe the best protection against debauched paper currencies and inflation is physical precious metals....

It's a settled argument in the goldbug world that the gold bull market is forecasting or calling attention to high inflation in the developed world. A Bloomberg editorial begs to differ, though.

Buried amid the standard reportese is a statistical review of worldwide gold demand in 2011’s first quarter. The data show that gold’s ascent is being driven by extraordinary demand from India and China, where rising prosperity is making it easier for millions of people to buy gold in all its forms, particularly jewelry.

The WGC estimates that Indian households own more than 18,000 metric tons of gold, the largest holding on the planet. (By contrast, U.S. official gold reserves total about 8,100 metric tons.) Indian consumers aren’t done buying. In this year’s first quarter, they purchased an additional 206 tons of gold jewelry and 85 tons of gold bars and coins. China’s appetite is growing rapidly and could soon overtake India’s.

Or come at it another way: Strip out Chinese and Indian purchases, and the rest of the world isn’t nearly so vibrant. Some new buyers have shown up; some prior speculators are cashing out....

This take on gold's rise - that it's due to Asian demand - is likely the reasoning used at the Federal Reserve to dismiss gold's rise an an indicator of inflationary trouble down the road.

Dallas Fed President Dennis Lockhart Says Inflation Won't Last

Lockhart is the latest spokesman for the Fed's contention that the current inflation is merely a spike and will be temporary. In a speech to a business group in Fort Meyers, Florida, he also said that the Fed's reliance on core inflation isn't total.

“While short-term measures of inflation have moved up rather strongly in the last few months, I hold to the view that this trajectory will not persist,”...

“Contrary to popular opinion, Federal Reserve officials do actually eat and fill up their gas tanks,” he said.

Lockhart said he thinks the U.S. central bank’s policy makers should focus on headline inflation that includes all prices....

He was also optimistic about prospects for U.S. economic growth.


That speech is easy to dismiss as an "I feel your pain" sympathy fest. It remains to be seen if his talk will translate to action, as he is a voting memeber of the FOMC.

U.S. Producer Price Index Shoots Up

Thanks to the 1.6% rise in the Producer Price Index for February, the unadjusted PPI is up 5.6% from where it was a year ago. The main villain was food price hikes: food rose the most in a month since 1974. Excluding food and energy, though, the core rose 0.2% in line with expectations.

However, expectations for the unadjusted PPI were for only a 0.7% increase. The Fed pays attention to the core rate, so its decision to stay the course yesterday will be reinforced.


The PPI number came out at 8:30 along with the awful housing-start figure. Putting the two together suggests the Fed will continue an accomodative policy. There's already whispers about a new quantitative-easing program even though none has been announced. As noted in the overnight report, gold yawned when the numbers came out - although those data could have limited a pullback that kicked in at 9:15. Within a half an hour, the metal rallied enough to wipe out that decline.

Shades Of Arthur Burns

One of the reasons why inflation got out of hand in the 1970s was Fed chair Arthur Burns inflating in response to the oil shocks. He did so because the oil hikes threatened growth. Needless to say, that response exacerbated inflation back then.

Now, one member of the FOMC - Atlanta Fed president Dennis Lockhart - said that the Fed should pursue the same policy again.

Lockhart emphasized that much would depend on the particular circumstances, especially whether higher energy prices were fully passed along to customers and whether consumers and businesses were beginning to act as if inflation would inevitably accelerate as a result.

So far, inflationary expectations remain controlled, largely because wages aren’t rising. “Wage accommodation of rising prices has the effect of institutionalizing and embedding inflation,” Lockhart said. “However, I do not see widespread wage pressures developing any time soon in the current circumstances of upwards of 20 million people either out of work or working part-time for economic reasons.”

Lockhart said his opinion is informed by research done by economics professor James Hamilton of the University of California at San Diego, who has found that episodes of prolonged and higher energy prices are almost invariably followed by recession

It's as if he wanted inflation. Needless to say, he denied that the Fed had any major responsibility for the surge in commodity prices.


Back in the early 1970s, it was held that inflation could not get serious when there was high
unemployment. Now, it's held that inflation can't get serious because wages aren't rising that much. The first proved to be a mistake. Will the second?

Global Inflation Expected To Pick Up; Possible 1994-Style Rout For Sovereign Bonds

That possible rout is not due to sovereign debt crises, but the need for central banks to raise interest rates to fight inflation. Already, some central banks are raising rates for that purpose. Others will have to join in too. The European Central Bank (ECB) is threatening to. Once the Federal Reserve and the ECB join in, there will likely be rate hikes all across the world. If so, then sovereign-debt securities will be in for a global squeeze like 1994's.

“There is a recipe for disruptive dynamics in markets if policy adjustments have to gather steam in a synchronized way,” said New York-based [Bruce] Kasman, a former official at the Federal Reserve Bank of New York who now oversees economic research at the second-largest U.S. bank by assets. Such a scenario could develop in 12 to 36 months and would “take a toll on risk assets. Bonds get killed,” he said....

Although he doubts developing countries are losing control of inflation, Jim O’Neill, the London-based chairman of Goldman Sachs Asset Management, says the yield on the 10-year U.S. Treasury note could “quickly” reach 5 percent if global growth is allowed to pick up faster than anticipated, forcing the Fed to start normalizing policy. The interest rate on the benchmark U.S. security was 3.49 percent on March 4....

“The biggest thing I worry about is a major sell-off in bonds like 1994,” said O’Neill, who helps to manage about $840 billion. “The ideal situation is the developed world comes back as the developing world slows, but what could happen is as the U.S. and others strengthen, they give the developing world another growth kick.”

The trouble is, central banks seem to be behind the inflation curve. (Veteran central-bank watchers won't be surprised.) There's some sign that inflation in mainland China is feeding on itself despite rate hikes by the People's Bank of China. One expert in the symposium said that central banks may let inflation run because of fears of financial instability.


As the fears engendered by '08 fade, it does look like the central banks have done it again - although they had help from too-optimistic sovereign debt markets. Real rates on global bonds are at about zero, providing further fuel for gold's climb.

Hyperinflation Unlikely?

The Ludwig von Mises Institute has webbed a thought-provoking paper discussing the possibility of hyperinflation. Its author, Vijay Boyapati, concludes that it's unlikely because hyperinflations tend to occur when the political classes are in charge of the money supply. When members of the banking class are, hyperinflations don't happen.

While the Federal Reserve has the theoretical power to force the resumption in credit expansion by monetizing enough public debt that the losses from the housing bust are wiped away, it is unlikely to do so. The Fed was created for the benefit of the banking class, and while it remains under the control of that class it will not pursue a policy that would lead to a breakdown in the monetary system from which the banking class profits.

His class analysis makes sense, unless a wide swath of the banker class finds a way to profit from hyperinflation. If they don't, they'll fight it tooth and nail; if they do, they may prefer to roll with it instead.

The way the banking system in the U.S. is set up now, the bigger banks may decide to roll with it. Losses on fixed-rate loans, which would be caused by hyperinflation, can be made up for by trading profits. There's also the possibility of TIPS-style loans coming in: i.e., loans that carry a rate of 4% plus the CPI with the remaining principal adjusted for inflation too. Such a loan would be like a one-year term whose amortization schedule would be recalculated with the new inflation figures factored in. The schedule could be adjusted as frequently as every month, provided that it's paid monthly.

TIPS-style loans becoming prevalent would also cushion an economy against deflation. The interest rate and principal would adjust downwards in such a case.

Of course, there's also the option of refusing to lend except with short terms, even for a long-duration loan like a mortgage. The TIPS option, however, is more palatable because it offers a quasi-fixed rate.

If inflation comes along, we may see such loans blossom in the private sector. There's already a precedent, in TIPS themselves, and the idea's easily adaptable to loans...even if less straighforwardly to self-amortizing ones.

Will Exporting Inflation Boomerang?

According to Martin Hutchinson of Money Morning, one of the reasons why U.S. inflation has been relatively tepid despite healthy increases in the money supply is because the U.S. has been exporting inflation.

U.S. monetary policy has involved excessive money creation since 1995, fueling asset bubble after asset bubble. However, it has not produced inflation in the United States because the dollar is a reserve currency, so excess dollars flow to countries whose economies are more vulnerable to inflationary pressures.

In the 1990s, the excess dollars flowed to Argentina, whose currency was pegged to the dollar. The imported inflation wrecked Argentina's sound policies of that decade and contributed to a debt-fueled collapse in 2001. Since 2008, the excess money has gone to China, India, Brazil and other fast-growing emerging markets. It also has fueled a massive growth in foreign exchange reserves among the world's central banks. Central bank holdings of forex reserve have grown more than 16% per annum since 1998.

China, India, and Brazil all currently have massive inflation problems....

Those problems are likely to rebound to the U.S., as indicated by much stronger commodity prices. Adding to the trouble is the unlikelihood of the Fed raising rates until 2012.

It's now an open secret as to why: mortgage resets. In order to prevent a second collapse in the residential housing market, which is already clogged with excess inventory, mortgage rates have to be as low as possible. This graph shows another peak in resets, largely from option ARMs, coming this year:



If mortgage rates are as low as they are for the rest of the year, and for a time in 2012, then the reset demon will finally be laid to rest. There'll be a cost, no doubt about it; gold and silver are already set to become the new asset bubbles. I have to say that the U.S. is lucky that the deflationist view has taken hold in Wall Street and other money centres around the world. Had the bond vigilantes not been supine for the last couple of years, the U.S. economy would be in a terribly tough spot. Thanks to U.S. Treasuries being a bubble asset as of now, and thanks to government-guaranteed mortages falling into line, the U.S. might well escape the aftereffects of the last bubble with only a new asset bubble to show for it.

As of now, anyway.

Inflation itself might well be the next bubble in the U.S.

Hyperinflation: In The Near Future?

Over at LewRockwell.com, there's an interesting interview of Jorg Guido Hülsmann about the possibility of hyperinflation being engendered by the Federal Reserve's quantitative easings. Prof. Hülsmann made the point that the justification for QEII differed from earlier justifications: before, QE was said to be necessary to prevent deflation. Now, though, the Fed's rationale is to get the U.S. economy moving again. [One subsidiary reason: driving the greenback down would help exports.] He also noted that the Fed doing so helps the U.S. Treasury finance its deficits at historically low interest rates.

In other words, the overall supineness of the bond vigilantes and the bubbleish demand for U.S. Treasuries gives the U.S. government the opportunity to finance more spending at abnormally low rates. For whatever reason, nowadays is one of those time when the Fed can push down interest rates without a rebound due to inflation expectations ramping up.

Prof. Hülsmann believes that double-digit inflation will make its appearance in a few years, but is skeptical about a Weimar-style hyperinflation breaking out. He noted that, in Weimar days, more than 50% of the Weimar government's budget was financed by inflating. The U.S. government is nowhere near that level now. There would have to be sustained quantitiative easing for some time before that point has been reached.


Call me superstition-prone, but I believe hyperinflation won't be a real threat until it's generally accepted that hyperinflation is impossible. There's a real opening right now for some up-and-coming mainstream economist to make a splash by saying that limits on loan growth imply that the Fed cannot induce hyperinflation, because the banks won't follow through by lending excess reserves out to the point where the money supply explodes. Even if they were willing to, loan demand from creditworthy customers would block the excess reserves from moving into the economy to that extent. The "data" backing it up would, of course, be the excess-reserves situation since late 2008.

This kind of thinking is dangerous because it implies that the Fed can expand reserves limitlessly without engendering hyperinflation. Since the "new normal" has captured so many people's attention, I could see some tenure seeker arguing what I sketched out above. The paper would be called "Structural Impediments To Hyperinflation" or some such.