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FreeMarkets (99.32)

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October 27, 2010 – Comments (9)

One of the great fears gold bugs have is inflation.  Gold isn't an investment, it's a store of wealth - a hedge against inflation. 

The U.S. Treasury saw this issue years ago and created the I-Bond in 1998.  It actually paid you interest + inflation.   PURE GENIUS!  You could buy bonds, earn interest, be adjusted for inflation and NOT have to worry if a giant gold vein was found in Antartica!

On Jan 1, 1998 gold was trading at $285/oz.  By Jan 1, 1999 gold was at $287 and by 1/1/2000 it hit a whopping $282.  Gold was beaten! The I-Bond had proven that investors who just wanted to store wealth had a weapon beyond gold.

Here is a table of prices below:

Gold/Gas/Flour/Fed Rate prices in table below are all from January of the year.

YEAR     Price Gold     Inflation    Gasoline    Flour     FED Rate

1998        $285        1.48%        $1.19        29¢      5.56% 

1999        $287        2.62%        $1.08        29¢      4.63% 

2000        $282        3.43%        $1.39        28¢      5.45% 

2001        $271        2.63%        $1.51        30¢      5.98% 

2002        $278        1.51%        $1.19        32¢      1.73% 

2003        $344        2.31%        $1.41        32¢      1.24% 

2004        $416        2.52%        $1.64        31¢      1.00% 

2005        $428        4.64%        $1.76        33¢      2.28% 

2006        $530        2.05%        $2.17        33¢      4.29% 

2007        $640        2.74%        $2.55        35¢      5.25% 

2008        $840        4.88%        $3.00        42¢      3.94% 

2009        $870        (-1.25)%        $1.88        51¢      0.15% 

2010        $1120        1.54%*        $2.76        49¢      0.11%


Gold's value has increased by 392%.
Gasoline has increased by 131%.
Flour is up 69%.

During this time period (1998-2010), according to the U.S. Treasury, inflation increased by 35% (in other words, $1 is now worth 65¢.

But anyone can plainly see $1 in 1998 is NOT worth 65¢ twelve years later..  Maybe, just maybe you can argue $1 is worth 45¢.  The I-Bond has failed to keep up with the cost of real inflation and is a failed instrument, because the gov't continues to fudge inflation data.

So what's the point of all this?  Notice the year 2003 very carefully. Gold spiked around 50%, inflation (according to the U.S. Treasury) was a tame 2.31%, gas was still the same price as in 2000 and flour prices were the same from the year before.  But gold continued it's march in 2004 and beyond, gasoline and flour began to move up quickly, but no where near as fast as gold. 

Now look at that FED Rate more carefully and you'll see Gold is NOT a leading indicator of inflation, but rather it is telling you about the amount of fiat dollars in circulation. 

The I-Bond began to fail investors as the people in charge of the instruments fudged data.  This is the beauty of gold - you can't make it, you can't fudge it.  Either you have it or you don't.

Long-term, if your interest is to PRESERVE WEALTH, nothing beats gold.  Even if you bought gold in 1980 at $1,000/oz, you didn't lose any wealth when it dropped to $400/oz because the dollar got so strong.  The same goes for when gold rises - you aren't GAINING ANYTHING!  You are merely storing wealth.

But wait!  If "real" inflation isn't moving up as fast as gold, aren't you making money.  The answer is yes/no.  There will always be daily/weekly/annual price moves due to supply and demand, but they will even out over time.  The other important fact to remember is inflation can double without prices moving up at all.  What the #%$##!  Think about this hypothetical scenario - you invent a technique that lowers the cost of ALL production by 1/2.  The gov't instantly doubles the money in circulation and prices stay the same.  Inflation is 0%, but gold will double, because inflation in prices is not the same thing as money in circulation.

In fact, I consider the above situation the greatest negative effect of our Federal Reserve.  We've had 40 years without a gold standard.  40 years of better technology driving costs down, yet prices continue to rise.  So basing the value of a dollar on prices is pure nonsense - the dollars value can only be based on a fixed commodity like gold.

So beware of anyone selling gold as an investment.  It is not that type of instrument.

*Doubled semiannual rate since Nov data not yet released

SOURCES:
Gov't Inflation Rate: http://www.treasurydirect.gov/indiv/research/indepth/ibonds/res_ibonds_iratesandterms.htm

Gold Prices: http://www.kitco.com/scripts/hist_charts/monthly_graphs.plx

Gasoline Prices: http://www.oregon.gov/ODOT/CS/FS/gas_prices.shtml

Flour prices: http://data.bls.gov:8080/PDQ/servlet/SurveyOutputServlet;jsessionid=62305ee1f47d67430594

FED Rates: http://www.federalreserve.gov/releases/h15/data/Monthly/H15_FF_O.txt

 

 

9 Comments – Post Your Own

#1) On October 27, 2010 at 1:18 PM, davejh23 (< 20) wrote:

Nice post.  Anyone buying TIPS at a negative yield is going to get burned.  Shadowstats is reporting inflation at something like 6.5% while the gov't is reporting 0.1%, and no COLA for SS recipients.  The gov't will always under-report inflation by a wide margin, so TIPS are useless...a guaranteed un-safe investment.

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#2) On October 27, 2010 at 3:58 PM, Momentum21 (98.05) wrote:

TIPS are useless...a guaranteed un-safe investment.

Kind of a strong statement, no? Anything can happen going forward but TIPS have done OK for me lately...see here. 

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#3) On October 27, 2010 at 4:02 PM, Momentum21 (98.05) wrote:

Sorry...try here

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#4) On October 27, 2010 at 6:22 PM, helicopterfool (25.35) wrote:

great post +1 rec

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#5) On October 27, 2010 at 9:42 PM, JakilaTheHun (99.93) wrote:

Good blog, but I disagree with it vehemently. There are also numerous errors.


During this time period (1998-2010), according to the U.S. Treasury, inflation increased by 35% (in other words, $1 is now worth 65¢.

If inflation increased by 35%, a 1998 dollar would be worth 74 cents in 2010 dollars. Not 65 cents. 

You divide $1 by 1.35, which gives you 74.  Or in other words, your calculation understands the value of the dollar by about 12.5%; which is a very significant amount. 

 

 because the gov't continues to fudge inflation data.

If the US government fudged inflation data, market participants would demand higher interest rates to compensate for the real inflation rate.  This has not been observed, so you are essentially arguing that free markets do not work. 

 

Now look at that FED Rate more carefully and you'll see Gold is NOT a leading indicator of inflation, but rather it is telling you about the amount of fiat dollars in circulation. 

If this were true, then the supply of money in the United States decreased by about 80% - 90% from 1982 to 1999, and prices in 1999 would have been similar to prices 50+ years earlier. 

 

The I-Bond began to fail investors as the people in charge of the instruments fudged data.  This is the beauty of gold - you can't make it, you can't fudge it.  Either you have it or you don't.

You can fudge data.  You can't fudge markets.  The current systems relies on free markets to determine currency prices (with the exception of many East Asian nations, whose governments are intervening in the markets in order to distort them.)

Gold can be fudged by the government very easily. Gold is a peg.  All the government has to do is change the peg. This is much simpler than trying to alter the dynamics of supply and demand. Note that many East Asian nations have adopted currency pegs, which mimic the disastrous affects of the gold standard in some ways.

 

The gold standard is the most anti-free market form of currency out there. The government sets an arbitrary price level for the currency peg; and then free markets are stifled.  What happens is that gold's underlying movements create market distortions that deter currency markets from reaching their natural (and optimal) equilibirum.

This is precisely what happened with the Great Depression.  It's happening now, as well, as East Asian governments (and the Eurozone, as well) have distorted the natural markets for currencies to such a great extent, that US interest rates can not reach a healthy level, and the US also has an unnaturally large current account deficit. 

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#6) On October 28, 2010 at 10:18 AM, Gemini846 (88.63) wrote:

I was hoping this would be about bond funds. I'm in a quandry.

I honestly think Gold right now is Bubblicous. I'm not saying it can't go higher, but there doesn't seem to be much room for return. Of course bonds are the same way, but bonds at least have the yield.

Do bond funds get most of thier return from trading the bonds (ie prices) or do they get their return from the yield?

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#7) On October 28, 2010 at 12:07 PM, MegaEurope (22.67) wrote:

Do bond funds get most of thier return from trading the bonds (ie prices) or do they get their return from the yield?

Like the average stock fund, the average bond fund has a slightly negative return from trading.

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#8) On October 28, 2010 at 2:26 PM, FreeMarkets (99.32) wrote:

#5 - Point taken on value of dollar.

As for "You can fudge data.  You can't fudge markets."

Exactly then what is happening when the FED buys Treasury Bonds?   Obviously this is a rhetorical question. Essentially there is no buyer, so the FED steps in and prints money to buy the bonds. 

I do agree that by fudging the bond market other issues will take place (i.e. inflation).

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#9) On October 29, 2010 at 11:44 AM, JakilaTheHun (99.93) wrote:

FreeMarkets,

Every action the Fed takes has a counter-response by the market.  If the Fed was inflating the Dollar at a high rate, the market would respond by jacking up interest rates significantly.  This would harm the US government because we would have a more difficult time financing our debt; which would then create an incentive for the Fed to stomp interest rates down.  

Hence, the market is self-regulated to a large degree. While the Federal Reserve is not a 100% "free market" system, there really is no such thing when it comes to currencies.  The Fed comes fairly close, however, and all the Fed is really trying to do is emulate the money supply that a hypothetical 100% free market would produce. 

Currency pegs, on the other hand, are very similar to price ceilings and rent controls, in that the value of currencies is artifically pegged to some unrelated object.  This creates room for major manipulation by governments.  

If a nation wants to spend like a drunken sailor, all it has to do is re-value the peg with the flip of a legislative switch.  It's been done time and time again. 

It's much more difficult for a nation like the US to "devalue" the currency because its currency is unpegged and tied to market mechanisms.  If the Fed overshoots, and increases the supply of money too much, all that happens is that the US has to pay higher interest rates, which then forces the Fed to stomp down rates by weakening money supply.  

Hence, while we could debate the Fed, I see no way that a gold peg is not anti-free market.  It's the very definition of a fixed market. 

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