Friday, October 26, 2007

The Fed Rate Cut & The Gold Price

A strange notion has been spread among some pro-inflation supply-siders. Namely, that interest rate cuts and higher money supply might actually strengthen the dollar and so lower the gold price and consumer prices. The idea is that the interest rate cuts will strengthen economic growth and therefore increase the supply of goods and services even more than the supply of money, leading to lower, not higher, prices. The idea is really so absurd that I wouldn't have bothered refuting it hadn't it been for the fact that pro-inflation supply-siders are so influential within the Republican party and pro-Republican media outlets like National Review and Investor's Business Daily.

The idea that even the short-term elasticity of production to money supply is more than 1 is of course not backed by any empirical evidence whatsoever and would require completely unrealistic assumptions about how the economy works. So there is not really much to refute as no evidence exists. However, just to illustrate how absurd the theory is and how out of touch with reality these supply-siders are, let's look at what one of them, Larry Kudlow, wrote just after the Fed rate of September 18:

"I also suspect that over time, the improved economic growth outlook for the U.S. will actually strengthen the dollar’s exchange rate, in part because the interest tax on money has been lowered.

And while gold did rally immediately after the Fed move, I would look for some gold weakness along with a better dollar."

Almost six weeks has gone now and gold is now trading at more than $785 per ounce of gold, up 9% from the level it stood at before the Fed rate cut. One can really wonder when that gold weakness that Kudlow predicted will come. The truth is that it's not going to come anytime soon. While temporary corrections will certainly come, the trend will however certainly be upwards due to the massive inflation unleashed by the Fed. I regard it as a near certainty that gold will push through the 1980 all time high of $850 per ounce within the coming 12 months-maybe even as soon as during 2007, although that is less certain.


Anonymous Per-Olof Samuelsson said...

History repeats itself... When Nixon severed the tie between gold and paper "money" in the early 70s, the monetarists predicted that the gold price would plummet. Austrians predicted that it would go through the roof.

Murray Rothbard had a salient comment on this in "The Case for a 100% Gold dollar": "Did [the monetarists] graciously acknowledge their error and hail Mises and his followers for being right? To ask that question is to answer it. To paraphrase Mencken, that sort of thing will happen the Saturday before the Tuseday before the Resurrection Morn."

10:45 AM  

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