Money Supply As An Inflation Proxy
The Federal Reserve's original mandate from Congress was to preserve the national currency as a store of value by maintaining price stability in the domestic economy. The Fed mainly influences price inflation by expanding and contracting the "Money Supply" through various machinations. In overly-simplistic terms, if the amount of currency and credit outstanding just keeps pace with the volume of transactions in the economy, then Fed policy should have minimal influence on prices. The currency should more or less maintain its value.

The chart on page 9 compares the money supply with the gold price. We plotted a series called FTTM (Fed & Treasury Total Money) against the price of gold for the past 30 years. We made the beginning value of each equal 100 and tracked them year by year. As we saw in the earlier gold chart, the price of bullion remained in a steady range until 2004 even though the Money Supply kept increasing. But as Money Supply accelerated, especially in the 2008 crisis, we saw the gold price start to rise out of that $200-$400 range in which it had traded for so long.

The next chart focuses in on that latest 10 years to see what was happening. Lo and behold... their trends were right on top of each other. Since 2002 both the money supply and the price of gold have multiplied 5-fold!

What we understand from this is that for the past ten years gold's price has been tracking the Money Supply even though the expansion of money has not shown up yet in the traditional CPI measure of inflation. Gold seems to be anticipating inflation!

The chart on page 10 is very busy, but it shows the moderating trend of inflation from 1990 to 2001, when gold's price bottomed around $270. It shows CPI's move back up to 5.6% in 2008, its recessionary plunge into deflation territory and a very quick surge to over 3% through May 2011.

We remain convinced that the erosion of currency values via inflation is the main driver of investor demand for gold bullion; an investment in gold is one way to protect the buying power of people's savings. While standard inflation measures have not seemed too worrisome recently, we do note that the price of gold has recently tracked the expanding Money Supply in apparent anticipation of the inevitable inflationary consequences. That seems reasonable to us.

Current Fed Chairman Ben Bernanke expects that the recent uptick in the CPI is "transitory". The gold market seems to be betting against his opinion. It seems to us that to own gold at $1,500 an ounce is to express a serious concern about price stability and about the likely future worth of paper currencies; not only in the US but throughout the developed world.

This seems a good time to transition our discussion to a consideration of a) the quandary in which the Fed finds itself, b) its likely behavior with respect to monetary policy, and c) the probable consequences for the price of gold.

Debt, Deficits and Denial!
Both the evidence and common sense indicate that investment demand for gold bullion is driven primarily by the waxing and waning of confidence in paper currencies as a store of value and reliable medium of exchange. Gold, which pays nothing and earns nothing, is mainly about jewelry demand when monetary inflation is low and stable, since there is little anxiety about the loss of purchasing power.

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