On the Relationship Between the Size of the Monetary Base and the Price of Gold

The strong correlation between the gold price, and the size of the US monetary base that has existed during the era of quantitative easing appears to be in breakdown:

fredgraph

To emphasise that, look at the correlation over the last year:

inversecorrelation

Of course, in the past the two haven’t always been correlated. Here’s the relationship up to 2000:

2000

So there’s no hard and fast rule that the two should line up.

My belief is that the gold price has been driven by a lot of moderately interconnected factors related to distrust of government, central banks and the financial system — fear of inflation, fear of counterparty risk, fear of financial crashes and panics, fear of banker greed and regulatory incompetence, fear of fiat currency and central banking, belief that only gold (and silver) can be real money and that fiat currencies are destined to fail. The growth in the monetary base is intimately interconnected to some of these — the idea that the Fed is debasing the currency, and that high or hyperinflation or the failure of the global financial system are just around the corner. These are historically-founded fears — after all, financial systems and fiat currencies have failed in the past. Hyperinflation has been a real phenomenon in the past on multiple occasions.

But in this case, five years after 2008 these fears haven’t materialised. The high inflation that was expected hasn’t materialised (at least by the most accurate measure). And in my view this has sharpened the teeth of the anti-gold speculators, who have made increasingly large short sales, as well as the fears of some gold buyers who bought a hedge against something that hasn’t materialised. The global financial system still possesses a great deal of systemic corruption, banker greed and regulatory incompetence, and the potential for future financial crashes and blowups, so many gold bulls will remain undeterred. But with inflation low, and the trend arguably toward deflation (especially considering the shrinkage in M4 — all of that money the Fed printed is just a substitute for shrinkage in the money supply from the deflation of shadow finance!) gold is facing some strong headwinds.

And so a breakdown in the relationship between the monetary base has already occurred. Can it last? Well, that depends very much on individual and market psychology. If inflation stays low and inflation expectations stay low, then it is hard to see the market becoming significantly more bullish in the short or medium term, even in the context of high demand from China and India and BRIC central banks. The last time gold had a downturn like this, the market was depressed for twenty years. Of course, those years were marked by large-scale growth and great technological innovation. If new technologies — particularly in energy, for example if solar energy becomes cheaper than coal — enable a new period of spectacular growth like that which occurred during the last gold bear market, then gold is poised to fall dramatically relative to output.

But even if technology and innovation does not produce new organic growth, gold may not be poised for a return to gains. A new financial crisis would in the short term prove bearish for gold as funds and banks liquidate saleable assets like gold. Only high inflation and very negative real interest rates may prove capable of generating a significant upturn in gold. Some may say that individual, institutional and governmental debt loads are now so high that they can only be inflated away, but the possibility of restructuring also exists even in the absence of organic growth. A combination of strong organic growth and restructuring would likely prove deadly to gold.

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Does Easy Monetary Policy Enrich the Financial Sector?

Yesterday, I strongly insinuated that easy monetary policy enriches the financial sector at the expense of the wider society. I realise that I need to illustrate this more fully than just to say that when the central bank engages in monetary policy, the financial sector gets the new money first and so receives an ex nihilo transfer of purchasing power (the Cantillon Effect).

The first inkling I had that this could be the case was looking at the effects of quantitative easing (monetary base expansion) on equities (S&P500 Index), corporate profits and employment.

While quantitative easing has dramatically reinflated corporate profits, and equities, it has not had a similar effect on employment (nor wages).

However there are lots other factors involved (including government layoffs), and employment (and wages) is much stickier than either corporate profits or equities. It will be hard to fully assess the effects of quantitative easing on employment outcomes without more hindsight (but the last four years does not look good).

What is clear, though, is that following QE financial sector profits have rebounded spectacularly toward the pre-2008 peak, while nonfinancial sector profits have not:

Yet it is not true that in recent years the growth of financial profits or financial assets has been preceded by growth in the monetary base; the peak for financial profits occurred before QE even began. In fact, the growth in the monetary base from 2008 reflects a catching-up relative to the huge growth seen in credit since the end of Bretton Woods. During the post-Bretton Woods era, growth of financial assets in the financial sector has significantly outpaced growth of financial assets in the nonfinancial sector, and growth of household financial assets:


This disparity has not been driven by growth in the monetary base, which lagged behind until 2008. Instead it has been driven by other forms of money supply growth, specifically credit growth.

This is the relationship between financial sector asset growth, and growth of the money supply:

And growth of the money supply inversely correlates with changes in the Federal Funds rate; in other words, as interest rates have been lowered credit creation has spiked, and vice verse:

The extent to which M2 is driven by the Federal Funds rate (or vice verse) is not really relevant; the point is that the Fed’s chosen transmission mechanism is inherently favourable to the financial sector.

The easing of credit conditions (in other words, the enhancement of banks’ ability to create credit and thus enhance their own purchasing power) following the breakdown of Bretton Woods — as opposed to monetary base expansion — seems to have driven the growth in credit and financialisation. It has not (at least previous to 2008) been a case of central banks printing money and handing it to the financial sector; it has been a case of the financial sector being set free from credit constraints.

This would seem to have been accentuated by growth in nontraditional credit products (what Friedrich Hayek called pseudo-money, in other words non-monetary credit) in the shadow banking sector:


Similarly, derivatives:


Monetary policy in the post-Bretton Woods era has taken a number of forms; interest rate policy, monetary base policy, and regulatory policy. The association between growth in the financial sector, credit growth and interest rate policy shows that monetary growth (whether that is in the form of base money, credit or nontraditional credit instruments) enriches the recipients of new money as anticipated by Cantillon.

This underscores the need for a monetary and credit system that distributes money in a way that does not favour any particular sector — especially not the endemically corrupt financial sector.

UPDATE:

Tyler Durden answers my question in one graph:

Does the Fed Control the Money Supply?

It depends how you define money.

The Federal Reserve controls the monetary base, and has vastly increased it as a result of quantitative easing:

But that’s not the same thing as the money supply. The money supply is controlled by fractional lending by the banking institutions. More “money” comes into existence as more credit is extended. Banks can lend and lend and lend the monetary base up to the reserve requirement (ten times the monetary base, at present). You’d think that profit-hungry banks would lend all the way up to the reserve requirement, but right now that isn’t the case — a huge amount of the monetary base is sitting unused as excess reserves:

This means that while the monetary base has tripled, the money supply (M1) has not surged nearly as much:

But there is a much bigger factor here; M1 only deals with the obvious side of money supply — lending by financial institutions to businesses and consumers. There exists another banking system between banks and hedge funds where credit expansion takes places much less directly and obviously, via securitisation and rehypothecation — for example collateralised-debt-obligations (CDO), mortgage-backed-securities (MBS), etc. Here’s a recent chart of credit creation via these pseudo-monies:

Simply, the Fed’s huge expansion of the monetary base has still failed to prevent the contraction of this strange and exotic part of the “money” supply stemming from the 2008 Lehman incident, and surely to be significantly worsened by the ongoing implosion in Europe. It has failed to prevent the sector from deflating and sucking down the wider economy.

In the years preceding 2008 the definition of “money” became extremely loose. When securities made up of sub-prime mortgages which are in arrears comes to pass for “money” — and came to stand on balance sheets as debt — it should have been painfully obvious that modern finance had mutated into an uncontrollable monster, and that no amount of quantitative easing could prevent prevent the inevitable credit contraction from blown-up asset prices tanking.

The shadow banking sector was never “too big to fail”; it was too monstrous to succeed.