Tag: inflation

Gold or Dollars?

Is Gold Really A Superior Investment?

I’m sure you’ve heard about the steady rise in gold prices over the last several months. You may have also seen the advertisements from gold investment companies pushing the purchase of gold, or heard predictions about even higher gold prices as world currencies struggle.

And just yesterday, the world’s first “Gold ATM” machine was unveiled in Abu Dhabi (Gold ATM Machine, Financial Times).

Gold dispensing machine in Abu Dhabi

We have to take a step back and ask ourselves about the true underlying value of gold.

Why is it valuable?  Because people demand it, and there is a relatively limited world supply.  Why do people demand gold?

It’s not like gold will sustain you: you can’t eat or drink it, nor does it have utility in and of itself.

No, the reason gold has value is because it can be exchanged for money which, in turn, can be exchanged for goods or services.  So the value of gold is derived from the very same place as is the value of money:  access to underlying goods and services.

The actual value of gold, however, is entirely dependent on other people’s demand for gold, given limited supply, much like fine art.  Unlike money, you cannot actually use gold for transactions:  have you tried to use a bar of gold at your local restaurant or car dealer, for example?

Think about it: if for some reason gold fell out of favor — let’s say someone discovered it was toxic — then gold would no longer be desired as an indirect means of exchange — having to first be exchanged for currency — and its price would drop to nothing, quite independently of the value of money itself.

The value of money it also dependent on its demand, which in turn depends on the acceptability of the currency on the world stage as a unit of exchange.

Dollars are accepted as currency and retain their value as long as the underlying real U.S. economy continues to be productive, and as long as the world supply of dollars does not outstrip the world demand for dollars.

Gold bars

Dollars are suffering at the moment for two primary reasons:  the attack on private industry by Obama’s policies, and the excessive world supply of dollars.  Both of these factors drive down the value of a dollar, and drive up the number of dollars that a bar of gold commands.

by Sherry Jarrell

Should you invest in U.S. bonds? Part 3

This is part three of a multipart series on the factors that drive U.S. and foreign bond prices and yields.

[Part One is here, Part Two here, Ed.]

The yield on a bond is made up of several components. Some think of the return on a bond as the sum of the risk-free rate of interest (how impatient we are to get our money back, or how much we need to be compensated to delay consumption) and a risk premium (the additional return we require to compensate us for the risk of default, the risk the bond will be called, the risk of inflation reducing the purchase power of the repaid dollars, and many other sources of risk as outlined in the most recent article in this series).

Another useful way of thinking of the return on a bond is as the sum of the real rate of interest and the expected rate of inflation.  But what is the real rate of interest?  We never actually observe that rate, unless of course the inflation rate is zero and then the real rate is just the nominal rate set in the market.

It is useful, however, to think about what drives the ability of a company to generate a real rate of return to lenders, for this is essence of capitalism and risk-taking and creating economic value and growth.

Bond traders

A firm’s asset cash flows support the real returns to its lenders – all kinds of lenders (debt, equity, hybrid, and derivative security holders). A firm will want to borrow more, and is willing to pay a higher interest rate for those funds, the more profitable are the projects they want to undertake, or the greater the number of profitable projects. Profitability, in turn, is determined by the relationship between demand and supply:  how much does society value a good or service, and how many resources does the business use in producing the good or service.  As the marginal productivity or efficiency of a business goes up, it can afford to profitably fund more projects.  So the core driver of the real return on bonds is the strength of the underlying economic activity of the private economy.

Or, when viewed from the investor’s side, note that an investor will purchase a bond, or lend money to a company, if they expect to earn a return sufficient to compensate them, first, for delaying consumption and, second, for bearing the various sources of risk or uncertainty associated with the bond’s cash flows or return.

By Sherry Jarrell

The Fed’s Exit Strategy

The Federal Reserve finally addresses how it plans to unwind trillions in toxic assets

Finally, we hear from the Federal Reserve about how they plan to unwind the billions of dollars of toxic assets they purchased over the last 18 months or so without creating further distortions in the U.S. and world financial markets (Fed lays out exit detail). This after the Fed barely acknowledged one of the most dramatic runups in the money supply in U.S. history.

Brian Sack, EVP Markets Group, Federal Reserve
The announcement came in a speech by Brian P. Sack, the executive Vice President of the Markets Group at the Fed.  I am impressed by this guy. He seems to know what he’s talking about and seems to understand how markets and fed policy interact.

In earlier posts I wondered aloud how the Fed might accomplish this tricky task. It is a very delicate balance between reducing the money supply too quickly, which would spike short term rates, and too slowly, which would increase long-term rates due to worries about inflation (which occurs when money growth is higher than the economy’s real growth, even if money growth is falling).

The Fed, the article explains, apparently intends to let $200 billion of the estimated $1.25 trillion in new money supply simply “mature” by the end of 2011 without replacing it. This represents largely toxic assets. The Fed might let another $140 billion of Treasuries it purchased during normal open market operations mature at the end of 2011, but they aren’t committing to that.  So that’s about $340/$1,250 or about 35% of the historic increase in money supply that may be vaporized over the next 21 months. What about the rest?  It would be nice to know but….

The Fed is doing the right thing by explaining its policy intentions — ANY of its policy intentions — to the markets.  Markets want, need, and deserve information from our officials, something that has been sorely lacking of late. With information, lenders and borrowers can plan, they can optimize. Without information, guessing, withdrawing from the market, and fear rule the day. Not a good environment for economic recovery.

by Sherry Jarrell