- Percy L. Greaves Jr., Mises Made Easier

Occasionally I hear the odd guest on CNBC or Bloomberg Radio who lays blame for the crisis in exactly the right place - the Federal Reserve System in the U.S....or central banking more broadly.

These extremely influential institutions ostensibly exist to regulate prices, employment and interest rates by way of control over the money supply. They do this by inflating bank reserve credit, on which the banks can pyramid, thus essentially abrogating the role of interest rate determination by the market.

That is, the central bank tries to determine interest rates as far as it can. The rationale for this policy is to attain full employment and price stability, and to otherwise manage economic affairs.

Any economist whose lenses aren't blurred by the fatal errors of the neo-classical doctrines is immediately capable of spotting the problem with that policy foundation. Unemployment could scarcely exist on a free market, where the government did not interfere with the price of labor. Just like shortages of goods cannot really exist in a market where their price is free to adjust to the reality of existing conditions, there can be no excess labor unless the government intervenes to artificially boost its price. It's the same principle. It is a simple economic fact - free of political considerations. Labor is an economic good primarily because it is scarce.

Moreover, whether we are talking about labor legislation or the central bank trying to manage growth, prices and interest rates, it amounts to economic management, even planning.

The apparent effect of the policy is to bring about a boom in investment and consumption... the building up of bubble companies and uneconomic enterprises relying on the continued increases in the selling prices of the goods they deal in - be it widgets, homes or securities.

These price increases are afforded by regular money debasement, which is one of the economic consequences of an increase in the supply of money in particular. So it is illusory.

In reality, as Rothbard points out, the boom "is actually a period of wasteful misinvestment. It is the time when errors are made, due to bank credit's tampering with the free market".

So this policy, and the booms it engenders, crowds out real savings (by pushing rates below market), and investment comes to rely on the continued "stimulus" of money creation or from borrowing overseas.

Ultimately, it further lays the seeds of its own demise because the process invariably arrives at a point at which the central bank must desist if it does not want to prompt a run of confidence in its notes, leading to hyperinflation.

This is why we say the policy is "unsustainable."

Thus it tries to withdraw the stimulus or "tighten" money and credit - explaining that the overheated economy might produce inflation. The error in its thinking is that it is managing a delicate balance between price stability and growth...that it checks market failures, and can know the unknowable (the future).

In fact, almost all economists would agree, it cannot produce growth. It's like the analogy of pushing on a string.

The Fed's policy can only increase employment by decreasing the relative cost of labor through inflation (the expansion of money supply relative to demand). And as one of the largest of interventions conducted by government policy, it only produces more instability - i.e. the boom-bust cycle as well as interest rate and foreign exchange volatility eventually.

Technically, tampering with the rate of interest produces disequilibrium as a mismatch between consumer preferences and producers' investment plans - during the boom phases. Effectively, it taxes long run growth, and is but a massive redistribution of wealth from savers to borrowers and speculators.

The bust, which often begins with the onset of a financial crisis, brings much pain, and threatens job losses on a wide-scale. But this is because the artificially low rate of interest produced by the previous policy, which could not be sustained, produced waste, a "cluster of error" as Rothbard called it. This "malinvestment" or uneconomic activity is essentially exposed as the subsidy is withdrawn.

In his book, America's Great Depression, Rothbard posits the error in Marx's reasoning,

"In the purely free and unhampered market, there will be no cluster of errors, since trained entrepreneurs will not all make errors at the same time."

What you see then is basically the widespread failure of parasitic enterprises that could not survive on their own - without the handouts and support of the central bank. This is the empirical evidence that should indict any inflation policy. But, the bust still merely represents a return to natural market ratios.

"The 'depression' is actually the process by which the economy adjusts to the wastes and errors of the boom, and reestablishes efficient service of consumer desires. The adjustment process consists in rapid liquidation of the wasteful investments" (Rothbard)

It follows then, that "Attempts to interfere with free and flexible prices, wage and interest rates prevent recovery and prolong the depression period" (Mises Made Easier )

Efforts to stabilize the bust with even more inflation effectively prevent the liquidation of uneconomic enterprises necessary to return the economy to equilibrium, where markets reflect actual conditions.

Now, I'm not a policy maker. I don't want to suggest the best way to fix the world or argue why these theories are true. My chief concern is the future. And the evidence that most people would side with Marx on this (over Mises et al) is all I need to predict more inflation, war and higher gold prices.

Joe Public can't for the life of him figure out why it matters if interest rates are 1.5% or 1%.

He cannot connect the escalating price at the pump to the process of money creation required to bring about such a modest change in the interest rate. The tech bust was the fault of irrational speculators, and greedy investment bankers. The housing bust is blamed on Wall Street's larceny, his mortgage and real estate brokers, or the thrust toward deregulation. The painful increase in commodity prices is caused by too much growth. The growing trade deficit is caused by new competition from foreign countries. And so on.

For, Joe takes his cue not from Mises, but from the media and political classes under heavy influence by the progressive institutions.

Political leaders in Europe, meanwhile, are taking full advantage of Joe to wage a new war on capitalism from the left on grounds that American style capitalism is in dire need of more regulation.

This is the great evil of the inflation policy.

It is insidious. The great economists have all recognized this truth. It only produces the opposite of what it claims to accomplish. It also funds the growth of government and anti-capitalist sentiment, and other confused ideas that may lead, ultimately, to the general disintegration in the division of labor, the fabric of society. It promotes moral degradation and corruption, conflict, and finances wars. It is 80% of what's wrong with the world.

But for the most part, the voices of reason that point to this cause are trampled over by the rhetoric of the larger political class, which fear mongers people into clamoring for more money and credit.

This truth is evident in the Fed's actions. It has abandoned any remnants of conservatism, as have the other central banks worldwide. The helicopter blades are in full swing. So any enthusiasm about the world having reached this place where it is ready to turn a new leaf must be tempered by this fact.

The voices of reason, though on the beltway, are still only voices in the wilderness.

This alone suggests we are going to continue to see more inflation, taxes and government. The scary part is that this process is accelerating.

The next bubble may well be in gold.

Good trading,

Ed Bugos
for The Daily Reckoning Australia

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But so have gold bugs and, after today, maybe gold share investors also.

There are only two things gold bulls should worry about from this point forward, now that the general commodity correction is out of the way and the froth has been worked out of the market: deflation in the strict sense of the term (monetary, not asset deflation) or a suddenly brightening economic outlook, both of which, in this writer's opinion, would require a political austerity hardly imaginable these days.

As far as deflation goes, we saw that the Federal Reserve inflated its balance sheet by an astonishing US$600 billion (almost 70%) in September, $170 billion of which ended up as an un-sterilized liquidity injection into the financial system - also unprecedented any way it is measured.

It is almost as much as the entire U.S. banking system created in the 12 months ending August 2008. It is about 20% of the cumulative amount of reserves the Fed has directly injected into the banking system since its inception in 1913. In one month, the Bernanke Fed "printed" MORE money than the Greenspan Fed in its entire easing campaign from 2001-03 - on top of which the banking system created $1.5 trillion.

Let me be the first to tell you that this represents a deliberate and abrupt change in monetary policy.

The Fed is no longer sterilizing its liquidity injections by selling off assets - probably because it doesn't have any left. No one else seems to have caught on yet. The Fed is now printing with abandon, as literally as that can mean.

However, that isn't enough to convince the deflationists. They point out that banks aren't lending and that credit markets have frozen all over the world.

This is obviously true. However, it does not follow from this that there will be deflation.

Let me reiterate that first, whether deflation comes about or not (I think not), the financial crisis is deepening precisely because, up until last month at any rate, the Fed had not created much money, despite the massive rate cuts. This policy was unconventional and deliberate. It was aimed at gold.

It has produced many things that the Austrian business cycle theory would predict from the policy.

The enterprises that are failing today are boom dependent. They have come to depend not only on the artificial stimulus of lower interest rates, but on a continued expansion in credit and money supply.

Indeed, Fed and Treasury officials, the media and Wall Street all talk as if the economy could not grow if the banks were not producing new credit. For them, boom and growth are one and the same thing.

The market is telling you that some operations are uneconomical in the absence of this "stimulus."

If the Fed continued on its austerity program (with respect to the printing press), the dominoes would no doubt continue to fall. This would be a process of returning the economy to equilibrium, if you will.

That is the definition of a bust or recession. It would probably be deflationary.

The Fed wasn't aiming for that. It wanted only to put the squeeze on inflation expectations building in the gold and currency markets without undermining the boom. It was a bold and new move, but naive. But its actions can only suggest that it is realizing this, and is not prepared to do what is right - nothing.

Lending strikes are not new. They are typical at the height of a crisis.

The Fed has published data on reserves only up until the third week of September, so it does not yet reflect the $170 billion net increase in reserves created by the Fed through the entire month, as I had reported last week. However, up to Sept. 24, the Fed created some $84 billion in reserves, while the figure for total reserves increased by $67 billion (from $44 to $111 billion) in the same period.

Excess reserves, meanwhile, increased by about the same amount.

Don't get caught up in the numbers. These facts essentially support the view that banks aren't lending out those new reserves. However, this fact is neither new nor typically long lasting.

U.S. depository institutions are required to have about 10% of their checkable demand deposits at the Fed as reserve. This amount peaked at a little over $60 billion in the mid-'90s, declined to about $40 billion by the end of the century and has hovered around that number ever since, as if inflation did not exist. It pales in comparison with the more than $1.5 trillion in reserves that the Fed has pumped into the banking system in its entire 95-year history or the $4-5 trillion in deposits that the U.S. banking system has created on top of that in the same period (even after accounting for deposits destroyed).

This is leverage, but the Fed, not the stock market, controls the denominator.

The reason that total reserves have been shrinking has to do with reserve requirements.

Although savings deposits are often checkable in practice and can be accessed by debit cards, banks are not required to keep reserves against them. Therefore, banks like to sweep (and create) as many of these deposits as possible into the savings categories.

That's why there is an upward bias to the underlying trend in the ratio of excess to total reserves. It does not reflect an increasing tendency for bankers to restrict lending voluntarily, but likely understates the inflation in reserves.

But while the figure on total reserves may have become obsolete and lost much of its relevance, big changes in the data are always important and shed light on things.

Today, the Fed is opening new windows through which to transmit policy. It can inject liquidity directly into money markets, and now commercial paper markets. It can lend directly to primary dealers. It can buy mortgages. It can pay interest on deposits, which will have two effects: exposing the hidden reserves (above) and luring money into the Fed. The latter is deflationary, but the interest payments are inflationary, if "unsterilized."

At every crisis that is bigger than the last, the deflation argument is always compelling. But it is fundamentally misguided if it is related to the idea of asset deflation or deleveraging. These concepts are not interchangeable with deflation.

Deflation, for instance, hasn't occurred since 1933, but deleveraging and asset deflation have, often - last in the 2000-02 bear market, and even as the Fed and banking system created a bunch of money.

Banks don't make money on the interest differential from lending out other people's deposits. They make money by lending out more than they take in... by "creating" deposits (i.e., inflation).

This is what a fractional reserve banking system does. It will lend again once it is confident that the central bank is making funds easily available and stands ready to bail banks out. By not printing until last month and letting Lehman go, the Fed sent out mixed messages that it is only now clearing up.

Abolishing the Fed would be a great idea.

Your freedom would be secure. Recessions would be gone. Governments would not be able to increase spending without immediate retribution. Growth and equality would become synonymous.

Crazy?

Not really. It's basic economics.

However, it appears somewhat utopian given the public's attitudes about the market and politics.

Most of the world, led by its political leaders, believes that the economic crisis was caused by greed and excess in the private sector, that the market is inherently unstable or that deregulation was the culprit.

Even some Austrian School authors blame the repeal of Glass-Steagall - the New Deal-era legislation that prohibited bank holding companies from owning nonbank financial firms or competing with securities and insurance companies - for the crisis. That's ironic for reasons I won't get into here, but it is a qualified charge - meaning deregulation is a good idea only if the central bank didn't exist.

I personally don't agree.

Still, people by and large do NOT see monetary and fiscal policy as interventions causing disequilibrium.

They see them as offsetting and stabilizing institutions - safety nets and tools of economic and social management - as they were supposedly envisioned.

For this reason, I posit, central banks and governments do not have the political will it takes to do nothing.

The change in Fed policy last month proves precisely that, which is why gold should soar.

I believe the markets are wrong again to perceive a deflationary outcome. It is an entirely different monetary system than existed in the 1930s, when the Fed could not simply print up reserves.

Deleveraging and asset deflation are not bearish for gold, as they don't necessarily imply a contraction in money supply, and rarely have. They may be bearish for gold stocks, but they are bullish for gold prices, because they are the very factors that motivate the near- certain cries for new credit (or more money) arising from a bad understanding of the true causes of the crisis. They are not new and are ultimately dwarfed by the next crisis.

But maybe the deflationists will be right about the behavior of banks this time. They have been wrong at each point in history when the economy faced a crisis caused by inflation. The thymological (historical) experience is that when the Fed inflates, the banking system does soon after. The Fed has never inflated in one month as much as it did in September. So the odds are against deflationists.

Indeed, the money supply could grow 25-50% in less than a year if that liquidity isn't taken back.

Ultimately, though, both the prior boom and the bust can be explained wholly by the Fed's specific policies. As will the next boom... in gold mining!

Ed Bugos
for The Daily Reckoning Australia

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In just two months, the economic landscape in America has markedly changed. It will change in the rest of the world, too. And not for the better, despite the pleasantly surprising news that the U.S. House of Representatives actually rejected the $700 billion bailout - the Treasury's latest harebrained idea.

Maybe it demonstrates there is a limit to how much the American people will tolerate, at least from the greedy capitalists on Wall Street. After all, it is not like the plan was defeated because the public has grown tired of government interventions and schemes. It just did not like bailing out the brokers.

Still, the markets had not expected this outcome. And as you saw, there was a lot of momentum behind the bailout news.

That's why the Dow was off some 700 points Monday. When I heard they were going to raise the money for the plan from foreign governments, as opposed to printing it, I started drafting plans for a rally on Wall Street that might produce another pullback in gold.

However, I still thought it was going through. Notwithstanding such unexpected surprises, markets are generally moving in the direction that we expected. In the end, gold shrugged off the reversals in the dollar and oil.

Now, I think that the failure of this bailout increases the probability of a more inflationary solution.

The Fed and Treasury have worked very hard to outwit us gold bugs by doing everything possible to support the boom without resorting to the "helicopter" option, right up to the final draft of the bailout.

But believe me when I tell you I feel little personal joy about that prospect.

Gold bulls gave back very little following the Sept. 17 one-day reversal. Including the following day, the market rallied $145 points from trough to peak on the news of the Lehman Bros. and AIG blunders.

In the days that followed, the market developed a bullish formation that technicians refer to as an ascending triangle - a pattern of higher lows closing in on a horizontal line of resistance highs.

We can't say how the Fed and Treasury are going to react to this. I'm sure it hurt in the right places, and when people get hurt - wherever - their reactions are even less predictable than usual.

From my perch, in a quiet suburb on the outskirts of Vancouver, where Agora Financial hosts an annual investment conference, it looks as if they are out of ideas, or at least their best ones.

The printing press is all they've got (aside from the much-feared laissez-faire option). So sit tight. Gold is the safest asset class to be in right now. In the current environment, producing assets reign supreme.

In fact, I recently wrote of a buy signal in the major gold shares. This may not be what you want to hear if you are loaded up with exploration stocks. However, in the context of a fear-driven gold price advance, in which stock prices are generally in decline, the companies most likely to benefit are those that can translate the gain in gold prices most immediately to their own bottom lines. These include all producers, junior and major alike, although at first, the market will probably prefer the safer large caps.

But as they rise, the pressure will build and spread to the emerging producers and even development assets, if they are close enough to production. Exploration stocks have a life of their own. There are terrific buys in that space today too, but I believe the values in the near production stages offer just as much upside with a little less risk here. The right strategy will outperform gold and the average major gold stock over time. The million-dollar question, therefore, is which juniors offer the best risk-reward?

I've looked through hundreds of companies over the past two months alone.

I've assessed our general strategy and wondered whether to sell some of the stocks in our portfolio.

In fact, the reason this month's issue is late is that I have gone back to the drawing board a few times in the search for the most appropriate investment strategy in this space.

Notwithstanding the shifting macro winds, I think that in light of the significantly improved gold price outlook, it makes sense to hold onto the bulk-tonnage low-grade development assets in our portfolio.

However, the demoralized level of sentiment has opened up a new window of opportunity to cherry-pick those top-quality gold stocks for which we normally must "pay up." These are the "alphas." These are companies that either can generate cash flows internally, by actually mining, or are led by people with deep pockets or credibility... companies with strong balance sheets and diversified portfolios of high-quality assets in politically secure regions... with growth potential whose premium is lost in the current slaughtering.

They are not cheap relative to their peers, but they probably never will be.

They are cheap in the context of the gold price cycle.

And this may be one of the few opportunities we get to accumulate such assets at favorable terms. The market has discounted their growth profiles and prospects for higher gold prices as it has with any others.

Regards,

Ed Bugos
for The Daily Reckoning Australia

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Ben won’t be there long, anyway, especially if he mucks this up.

Maybe the new administration will replace him. Then he could write a book debunking gold bug myths about the Federal Reserve System, such as the one about how the Fed is “the engine of inflation.”

Anyway, the markets, overall, are performing as expected.

They are treating the gold correction as though it were a healthy mistake.

Not only did it weed out the weak hands, but it gave central bankers a false sense of security in the face of escalating energy costs. With gold in the doldrums, bond yields relatively low and stock prices recovering, all looked good for a relaxing summer vacation – at least until last week.

Gold bulls are popping with enthusiasm about the post-FOMC recovery in gold prices.

They should be.

After breaking through $920, the market almost shot clean through the May high of $940, staring the reversal point at $950-960 right in the face. The chart bias has turned bullish. I would expect to see support hold above the $900-920 level if the market were to backfill over the next few days – to validate my bullish outlook. But it’s not just technical. The market is doing all the right things, fundamentally.

It has realized that the Fed didn’t really mean what it said, and if it did, it isn’t all that, anyway.

The focus of the debate is shifting to areas that make the Fed uncomfortable: The Dow failed to breach 13,200 and the inflation story is heating up, despite ongoing cracks in the economy.

These things are driving gold now.

Bull markets are notorious for going much further than their earliest prophets ever imagined.

That’s the message in oil prices. As a gold bull, I am taking heed.

What the Fed didn’t anticipate was that the oil price rise would be so sticky that it would embolden the inflationary psychology with or without gold. And it cannot afford to lose control over bond yields.

On the other hand, it cannot afford to tighten.

It can only try to talk down inflation expectations.

A whole new generation has grown up since 1979. It is not used to a tough Fed. The toughest Fed it has seen was in 1994. And putting aside the character comparisons, I’ll tell you this – it was only after several years of inflationary fallout, when people finally began to worry more about inflation than deflation, that Volcker was hired with a political mandate to attack the inflation monster head-on. At the time, CPI inflation and interest rate levels were already high, and P/E ratios were half today’s.

The Bernanke Fed is nowhere near such a mandate. It cannot have anything more in mind than Greenspan’s gradualism. Yet even that is dangerous at this time.

The Greenspan Fed was raising rates during a period of economic stability (2004-2005). Today, the Fed is talking about raising rates in response to an inflation outbreak amid a financial crisis.

C’mon! How are you gonna ’splain that to the voters?

If Bernanke wants to survive long enough to secure another term, he’s not going to challenge the status quo, and the status quo is not willing to accept the kind of austerity package necessary to contain or defeat inflation. The Fed is damned if it does and damned if it doesn’t.

This means that prices will continue to rise until outright fear of inflation exceeds all others.

That’s why gold has the potential to catch fire here.

The market is beginning to understand this, too. It has seen Bernanke flip-flop from worrying about deflation to worrying about inflation a few times already. The Fed’s hesitation to act in last week’s Federal Open Market Committee meeting was like a starting pistol for this realization.

It’s too late to fix this break in confidence, and it’s too early for the Fed to really take it to inflation.

Watch gold prices double over the next year. My forecast is for gold to reach $1,200 by year-end, and $2,000 by next summer.

This may well be your last chance to buy the metal below $1,000 per ounce.

Ed Bugos
for The Daily Reckoning Australia

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What he was saying is that early in the inflation, the value of money does not drop as much because the individuals determining its value are used to it having a stable purchasing power. Expectations, however, will change as the inflation progresses, and eventually the value of money drops faster...

That is how, yielding to cries for more money and credit, the dog chases its tail right into hyperinflation.

The bull market in gold started on a transition to "the middle stages" of an inflation cycle that began with Greenspan's reign in the nineties. During that decade, the pundits argued that inflation was dead and that there was no longer any correlation between money supply growth and the price level, which was true if you forgave the method of calculation of both statistics, and ignored the technology bubble.

But, the fact was simply that we were in "the early stages" of a new inflation cycle.

The last one ended with Paul Volcker, Greenspan's predecessor. Volcker had resolve, but that's not saying much because America's policymakers had nothing left to lose by 1978. Attempts to lower the long-term bond yield failed through the seventies as it went to higher highs whenever the Fed stopped lowering short-term yields. By the time Volcker got in, the economy suffered almost a decade of rising prices and interest rates, the stock market was trading at less than 10 times earnings, the dollar made new record lows, there were long lines at the gas stations, and the banks (to buy gold), and the policy of expanding money (inflation) was no longer boosting employment or growth... and then, stagflation!

Only then did the central bank and government deal directly with the root cause of the problem.

They face too much risk today for that kind of resolve. The stock market is trading at about 20 times earnings and bond yields are in the low single digits. People are only beginning to see that inflation is not quite dead. They are not yet demanding higher wages and pushing up interest rates because of it, at least not widely. It is not yet causing unemployment. The inflation policy is still a useful tool for the expropriation of wealth under the guise of illusory booms. It is not yet producing results that will make it unpopular. If it was abandoned now, the detrimental effects would be great. They cannot afford it.

Naturally, this predicament all but guarantees the later stages of inflation, where "prices rise by more than the increase in the quantity of money" as people lose confidence in the value of money.

From there we get the combination of rising prices and recession that people who can't recognize the early stages of hyperinflation will call stagflation. I don't think we'll see that until the next recession, and if central bankers or politicians continue to bury their collective heads in the sand then, you'll see the "crack up boom," a term that readers of this publication are no doubt familiar with by now.

So it is that the current environment for gold couldn't be better. You have the Federal Reserve System slashing rates aggressively and leaning on depression era loopholes in order to stave off a financial crisis, which it caused by slashing rates and expanding credit too aggressively in the first place.

And it is doing it at a time when commodity prices are printing records that the pundits never imagined possible a decade ago, and when even the massaged inflation numbers are approaching the high end of a two-decade range! Combined with the bail out package offered by the government, where's the discipline that will deter the reckless lending tomorrow? If you understand recessions as corrections to natural market ratios, these moves will only continue to underwrite poor quality economic booms.

We are seeing the Federal Reserve make history by expanding its reach past the government T-bill market into the mortgage and brokerage businesses, which will only help it generate more inflation more directly in the future. You have a free-falling currency that can't seem to find a floor against other fiat never mind gold, national default rates running at a record pace, supply side shortages in gold caused by socialistic policies and resource constraints in some parts of the world, and so on.

You can add the fact that production costs in the gold business as well as MZM, the broadest measure of U.S. "liquidity", have both doubled since the bull market in gold began - raising the floor substantially.

So then, what triggered this gold correction?

The latest advance in gold kicked off with the spreading of the subprime crisis in the final months of summer 2007. The crisis has not likely peaked. Citigroup is predicting way more rate cuts ahead.

Why would a gold correction of any magnitude begin on the week that one of the largest brokers in the world blew up, especially when followed by the kind of policies that should have fired gold right up?

Was it a "sell the news" phenomenon? Maybe, but that would definitely mean buy this dip now.

Last week, the market expected the Federal Open Market Committee to cut its fed funds rate by a full percentage point, but it disappointed the market by cutting only three quarters of a point - on account that it was worried about inflation. The sentiment produced the best of all worlds: soaring stock prices and falling commodity prices, as if such a deep rate cut could actually boost growth and quell inflation all in one fell swoop.

C'mon. How's that again? That's right. The press told us the Fed was worried about stoking inflation expectations, so it held back the extra one-quarter of a percentage point.

Heck, it only needed to recognize that most of the leverage was concentrated on the bullish side of the commodity markets. By upsetting market expectations, this is where it would hurt the most. Add a conveniently timed rumor that the futures exchanges may lift margin requirements, and news that the Chinese had raised their reserve requirements, again, the catalysts for the correction becomes clear.

It's one of the main reasons I don't believe this correction. Most commodities are due for a correction of some magnitude, and that the dollar is due for a meaningful bear market rally, and that these things are going to cause choppy trade in gold. But gold should be able to decouple from those correlations as the market realizes that the bull market in commodities is about money, and that the dollar is not the only inflationary currency.

This advance in gold will continue without a serious interruption until either it is allowed to blow off on its own into an unsustainable froth, or the Federal Reserve targets inflation - by raising real interest rates (past neutral), or reserve requirements, or some form of credit tightening.

It does not have this resolve today, clearly.

Corrections are healthy. By all counts, one was due in gold anyway. The market was getting a little too far away from its 40-day moving average, and exhausted the $950 implied objective of last year's breakout weeks ago. If you are expecting the current leg to outperform the 2005-06 rally, as I am, you were/are expecting gold prices to make it past the $1100 level before experiencing an intermediate correction of the sort we saw in 2006 - 27% from peak to trough and lasting six to twelve months.

The current correction has been half that depth so far. There are similarities. But it has not triggered any real intermediate sell signals in my model. The bullish case for a climax at $1200 plus (before this summer) is not yet injured on the chart - so long as the bulls hold the line at between $850 and $900.

The last highest low in the intermediate (7-month rally) sequence is at $885 in the cash market. The market could just be making some elbow room for a lunge higher.

It could consolidate for a few weeks yet, as the Dow tests the parameters of its newly forming bearish trend. That conviction is young itself, and it is having trouble engaging because the Fed is fighting that trend. A rally in stock markets engendered by the Fed's rate cuts could alone reignite concerns about inflation, but if not, if it starts to fail, I expect gold will be ready to begin move to my $1200-1400 target.

And it could all happen in months.

Unlike the base and other precious metals, oil, and almost any other commodity, gold has not yet seen the kind of upside volatility that would force me to call a correction beyond what is considered normal.

Unfortunately, the situation is more tentative for gold share investors. A bear market on Wall Street means rising risk premiums and contracting value multiples, and gold stocks are not cheap. Mining companies are not immune to the effects of rising costs on production and development. They are businesses. And as shares, they are not immune to rising bond yields.

Bond yields are not rising right now, but they will. It's difficult to find values in the gold share sector today, at least at the mid to large cap levels. Consequently, I believe they will have difficulty keeping up with gold, especially if stocks are falling.

On the other hand, I'm finding many values in the juniors and small caps, many of which have been in decline since the 2006 peak in gold - and that have sat out the entire 400 dollar rally since August.

In some cases, the decline is warranted as they went to absurd values in the 2003-2006 period. In other cases the decline has left many juniors trading at or near their cash break up values.

The obvious point is that the seven month old gold rally has not reinvigorated much froth broadly. And the risk/reward ratio now favors the juniors, though because they are risk assets there is the chance that they could fall further if the general stock market environment continues to deteriorate.

My advice is to continue to generally overweight gold directly (physical or ETF), reduce or hedge your positions in the expensive mid to large cap precious metals producers, sell all your non-precious metal resource shares, and accumulate the best quality junior gold, silver and platinum assets from here on.

Regards,

Ed Bugos
for The Daily Reckoning Australia

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Now remember another one, "Don’t fight the Fed"?

Well, what happens when the Fed fights the trend, as it has been recently? Which axiom to believe?

Historically, the Fed loses that fight until the trend is ready to turn back around. Admittedly, the central bank’s inflationary policies will likely help this occur at a higher nominal dollar value than otherwise.

Nevertheless, the historical odds favor the trend over the Fed when these two maxims collide.

But putting aside my autistic wisdom for a moment, let’s consider what the Federal Reserve is doing for the trend in gold prices – a trend, I am loathe to inform you, which it is not fighting.

Let me sum it up: the trajectory of this bull trend shifted north when Bernanke took the helm of the Federal Reserve System, and that the policies pursued by the Bernanke Fed have confirmed the investment thesis driving the bull market in gold. As one pundit recently noted during a Bloomberg interview, "You gotta go with the inflation theme... it’s the only thing still working."

After upping the size of its new term auction facility from $60 to $100 billion this weekend, the Fed revealed another innovative tool that might help it manage liquidity in the banking system.

The new facility, the Term Securities Lending Facility (TSLF), will offer up to $200 billion in Treasury Securities to primary dealers in exchange for a wide variety of collateral the Fed has never before accepted, including private label mortgage securities. It also eased swaps with other central banks.

The controversy is that although the Fed has been allowed to accept mortgage backed securities as collateral since 1980, it has never outright bought them, and only recently enacted legislation that allows it to actually monetize them – which means to buy them without having to sell other assets.

Gold bugs have followed the Fed’s legislative changes with interest. This move should not surprise any of them, but it does hold a special significance in its long-term implications, and for gold prices.

And even though the Fed hasn’t expanded bank reserves or the monetary base much since August, it is helping the banking system postpone an increase in reserve demands triggered by criteria built into the Basel II framework, a generally accepted model for capital adequacy standards. By boosting the quality of bank reserves, even if temporarily, the Fed hopefully won’t need to increase the quantity of bank reserves, which have been sufficient to fuel an $800 billion expansion in the broad US credit aggregate, MZM, since August. That is 11%, or 15% year over year. The highest rate since 2002.

That is a bullish recipe for the precious metals. There is nothing more bullish for gold than a situation where the central bank refuses to acknowledge that it is pouring gasoline on a raging fire.

Forget the dollar, and oil. Those were just interim preoccupations.

The real bull market is about to stand up.

If gold prices are going to continue to drive through $1000, they are going to do it because the central banks are all inflating madly at the worst time. This means that a good old-fashioned bear market on Wall Street is sufficient to keep central bankers’ collective petal to the medal, and sustain the gold bull.

So far, the precious metals stocks have bucked the general stock market trend since August.

This is as it should be, and it is impressive because by most counts gold stocks are quite expensive relative to today’s gold price. But, investors are complaining about the underperformance of those stocks relative to gold, and also about the lackluster performance of their junior mining assets, which haven’t participated in the precious sector rally at all since August – when the current leg started.

There are a few explanations for this.

Perhaps John Embry said it best, at a gold conference in Vancouver recently, when he remarked that gold shares sometimes act like a bet on gold, but sometimes they just act like plain old shares.

We should leave it at that...however, that is not like me.

Historically, I have found that gold shares are susceptible to market declines, except occasionally during a major bull market advance in gold, when they tend toward counter-cyclicality – the more so as the bull market progresses. They will still fall during stock market panics, as all shares do, but they are likely to come back harder and hold their trends better. Still, since 2004, I’ve held the position that, as an asset class, gold shares would not outperform gold prices for the remainder of the primary leg.

I continue to think that, with the qualification that we are talking about the average gold stock.

Junior markets are wired differently. They do not correlate that well with the underlying commodity trend in the first place. In my experience, they correlate better with market attitudes toward risk.

Junior and small cap markets have never fared well in a general market meltdown because they are typically risky assets, and in a selling panic the crowd is averting risk.

The larger capitalization precious metal producers are different. The reasons for this are sound. But as a rule, speculative assets do well when the gambling environment is friendly.

However, within the small cap resource sector there will invariably be exceptions. It remains to be seen if the junior gold miners will be able to buck the general market trend, but there is a good chance they will. Many of them are cheap now, and the supply fundamentals for gold are tightening.

Production from many gold producing regions of the world is currently constrained by power shortages; and rapidly inflating development costs are causing the postponement of several otherwise promising development projects around the world. Meanwhile, gold producers need reserves!

The large cap producers are on the hunt for sound mining assets. And they aren’t going to be discouraged by a 20-30 percent drop in gold, or stock prices.

Regards,

Ed Bugos
for The Daily Reckoning Australia

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The whole truth is that gold has very few industrial uses at current prices. Gold is worth about 55 times silver and more than 3,000 times copper per unit of comparable weight. If it were as cheap as copper, we would have wired our houses with it, as well as the Internet; if it were even cheaper, you'd probably be sitting on it in the bathroom, as that Commie Lenin advocated.

We don't use gold in more common applications because of its finer qualities: relative scarcity, our vanity, to name just a few. And the bulk of gold's value is still monetary, a fact that its enemies are loath to admit. Consequently, changes in the price of gold tend to reflect mainly changing monetary factors.

Gold bugs can't ignore the market's judgment, either. They must acknowledge that the monetary demand for gold had in fact ebbed during the 1980s and 1990s in favor of the dollar standard - a standard launched by default in the early 1970s.

The waning view of gold as money helps explain why gold didn't keep up with the CPI through the '80s and '90s, despite the three-fold increase in narrow money (M1) and the five-fold increase in broad money (MZM). The bears claim this poor record shows just how bad an inflation hedge it is. But their time horizon is both short and selective. The full record of the Federal Reserve Note (since its 1913 inception) is poor.

I'll give the bears credit for identifying the drop in the monetary demand for gold as the reason it lagged the CPI in the '80s and '90s. But they are hopelessly naïve if they believe that the 35-year-old dollar standard is an evolution in the monetary system, as if it were progress. Gold served as the market's solution for money for thousands of years.

The government forced the dollar onto the U.S. producer by legal tender and other laws. It forced the dollar onto trading partners by extortion. These partners were already drowning in dollars no longer backed by gold. They had to choose between letting the whole system fall apart and using the new "dollar standard" to their advantage. America had the largest and most developed consumer market in the world at that time, and they all wanted in.

Fast-forward to today: After a couple of decades of experimenting with this system, it is no longer working to anyone's satisfaction. In order to maintain their trade advantage, America's trading partners have to inflate at an ever faster pace (than the Fed) and soak up increasing quantities of dollars. This scheme always was untenable, but now it's falling apart. There's even talk of the need for a new global reserve currency.

So far, the media spotlight has been on the euro as contender, but the media will see that is untenable too. Gold is really the only alternative to the dollar. But that's a lesson the gold bull market has yet to teach. Let me know when you can use the euro on the streets of Bombay or in a Wal-Mart in California as easily as you can use the U.S. dollar, or at least when the price of gold stops outperforming the euro. Then I might consider taking it seriously. Meanwhile, we're likely heading back to where this story left off in 1980.

Before I delve into a rudimentary analysis and probably futile attempt to value gold, let me admit that I don't know how high it is going to go. No one really does. We're all just guessing. A bull market in gold basically means that gold's monetary allure is on the rise. That is, market participants are beginning to prefer it again - either as a hedge against inflation (investment), a measure of monetary value, a means of international settlement, a monetary reference point, or even as a genuine medium. These reasons all constitute what I mean by "monetary demand."

Of course, no such thing as a bull or bear market in gold would exist if gold were already money, because the total demand for money does not fluctuate very much. On the other hand, the total demand for a particular kind of money may. The bull market in gold is a byproduct of the decline of the dollar standard. Not surprisingly, it is outperforming the CPI again.

If the CPI were an accurate measure of changes in the value of money, and the monetary demand for gold were constant, the CPI-adjusted gold price in the first chart above might represent some notion of fair value for gold prices. But the CPI is anything but a reliable measure of change in money values. Chances are it understates this problem.

I have been forecasting "Gold: $2,000-2,650" for many years now. My early forecasts, back in 1999 and 2000, called for a straight-up move to $2,000 per ounce. That forecast overestimated the willingness of investors to grasp the gold story and underestimated their addiction to the prevailing monetary policy, and I scrapped it in 2001 in favor of a more drawn-out affair.

I adopted the view that this bull market would last 10-15 years and include two-three sequences.

We are now on year seven of the current advance - the first primary sequence. There is little doubt in my mind that the dollar standard is on its way out and that the monetary demand for gold will return to the levels of the late '70s. But the exact prognosis is anyone's guess.

As a trader, I can tell you that nothing goes straight up. The market tends to change the rules just when most people have become accustomed to a particular set. Hence, every bull market contains surprisingly violent corrections. These corrections convince many latecomers that the bull market has ended.

None of the corrections we've seen in gold during the past seven years qualify as this type of correction. The rise in gold prices to this point has been steady and sustainable. For much of its rise, gold has been in a stealth bull market. But the gold price advance is no longer stealth. It's not as spectacular as oil's advance or some of the base metals' advance in 2006, yet. But the chart says it wants to go parabolic.

That's the good news. The bad news is that such moves bring in weak hands, which set the stage for a big correction. Remember this whether you want to trade the trends or buy and hold.

Ed Bugos
for The Daily Reckoning Australia

Editor's Note: Ed Bugos is a frequent contributor to Strategic Investment.

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