GoldMoney Alert - 15 June 2008

Time to "Wheedle and Cajole"

This past Friday The Wall Street Journal reported that the "U.S. continues to wheedle and cajole to shore up" support for its wars in Iraq and Afghanistan. Wheedling and cajoling can also be used to explain how the U.S. is trying to support the dollar. Barron's this weekend quotes a prominent bank economist as follows: "I think Ben [Bernanke] is bluffing. [He] is engaged in open-mouth policy in an attempt to stabilize the dollar."

There is only one way to strengthen a currency - raise interest rates. This reality is well documented throughout the entire monetary history of central bank interventions. We saw Paul Volcker rely on this fundamental tenet nearly thirty years ago, which was the last time inflation and other monetary problems caused the dollar to fall apart on the foreign exchange markets. He raised interest rates relentlessly until the bank prime rate hit 21%, which was high enough to convince the markets that he was serious about preventing a total collapse of the dollar. But Messrs. Paulson and Bernanke seem intent on taking a different course.

They are trying to change monetary history by ignoring this most basic principle of central banking. Rather than raise dollar interest rates, they are instead just jawboning.

We saw both of them in full force this past week, huffing and puffing about not ruling out market intervention and other steps to fight inflation. But what else would you expect them to say? Talk is cheap; action is dear. The bottom line is that we have been here before, but there is a significant twist this time around. It's their unadorned wheedling and cajoling.

The Financial Times reported this past Friday: "The 'strong dollar' campaign has switched into high gear. US Treasury Secretary Hank Paulson has conducted an aggressive lobbying drive behind the scenes in the Middle East and Asia. America's friends and foes have been left in no doubt that the enormous strategic might of the United States is now firmly behind the currency. From now on, they cross Washington at their peril." Was Mr. Paulson really threatening friend and foe alike with the U.S.'s "strategic might" in order to talk up the dollar? The FT wasn't the only newspaper to report as much.

The more important question though is whether the implied threat of "strategic might" is really enough to cause the dollar to change direction? No, because as noted above, higher interest rates rather than more rhetoric are needed to save the dollar from a total collapse.

As the following chart shows, the wheedling and cajoling and orchestrated media campaign is causing the dollar to bounce, but absent action by raising interest rates, this bounce will be short-lived. After the bluster, the major downtrend in the dollar will resume.

Markets don't respond to threats; they respond to fundamentals. And the fundamentals for the dollar are horrific. For example, the interest income one can earn on their dollars is less than the inflation rate, even when using the government's reported inflation rate, which is far less than the true rate at which prices are rising. In other words, inflation-adjusted interest rates are negative, which is very bullish for the precious metals.

Nevertheless, gold and silver have fallen back into support. But their charts in dollars and euros remain bullish.

Lastly, I often say that gold is very cheap, even though its price has risen more than 3-fold since 1999. Here is an important chart to illustrate my point.

When measured in terms of goldgrams, the price of crude oil closed this past week at a new record high, at 4.82gg per barrel. The historical average from 1946 until 2000 is 2.32gg per barrel. I chose 2000 purposefully to calculate the average price because even though the gold price has been rising since then, gold price capping by central bank intervention has distorted gold's price. So even though the gold price has been rising since 2000, gold's purchasing power today is far less than it should be. The gold price is not rising as fast as the dollar's loss of purchasing power. Based on its historical relationship to oil, gold should be twice its current dollar price. It is therefore very cheap indeed.

Governments are not able to cap the oil price. Central banks don't hold a large aboveground stock of oil with which they can use to intervene in markets. But they do hold a large aboveground stock of gold, which they actively use to keep gold from reach its underlying fundamental value. In other words, central bank price capping of gold has kept it at levels which make gold unbelievably good value.

Published by GoldMoney
Copyright © 2008. All rights reserved.
Edited by James Turk

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