Time Running Out for the U.S. Dollar

Jeffrey Nichols, Senior Economic Advisor to Rosland Capital

Managing Director of American Precious Metals Advisors

HIGHLIGHTS:

• U.S. dollar strength will be short lived

• Official GDP and inflation statistics present overly rosy picture

• Gold’s long-term drivers remain bullish

It’s now nearly two months since gold registered an all-time high of $1,227 an ounce, following a five-month run during which the metal rose more than $300 an ounce.

Gold’s strength last year reflected a number of factors: (1) record worldwide private investment demand; (2) net official purchases (after two decades of net selling) as some central banks sought insurance against further devaluation of their dollar-denominated assets; and (3) at times, a weaker U.S. dollar.

Since then, mostly reflecting a temporary “strengthening” U.S. dollar, the yellow metal eased off a bit, falling as low as $1,075 last week – a correction of some 12 percent – before recovering smartly at the beginning of February..

The catalyst to dollar strength – measured against the euro, Europe’s common currency, or a basket of key currencies – has been heightened fear of sovereign default. Most recently, fears that Greece will be unable to meet its public debt obligations has pushed the euro to its lowest point in six months and the dollar to its highest level in five months against a basket of currencies.

It baffles me that so many foreign-exchange traders and institutional investors around the world think of the dollar as a “safe haven.” Just look at the facts:

A proposed a $3.8 trillion budget for fiscal 2011 projects the Federal deficit will balloon to a record $1.6 trillion following last year’s $1.4 trillion deficit – and there is not much hope of bringing the deficit down to acceptable levels in the next few years, particularly with a persistently weak economy, persistently high unemployment, falling tax revenues, and, eventually, rising interest rates that will push the Treasury’s borrowing costs much, much higher.

Meanwhile, the Federal Reserve continues, as it must, to buy Treasury and federal housing agency debt and to hold its key Fed funds policy rate near zero.

Our dysfunctional government lacks the ability to deal with America’s economic problems and the public lacks the stomach or the wallet to take the painful remedies necessary to put America back on the right track.

It will soon become clear that our economy is performing much worse than headlines lead us to believe.

Last week, the Commerce Department reported GDP grew by 5.7 percent in the fourth quarter of 2009. Not mentioned widely in the press, 60 percent of this gain was inventory-related . . . but not even an increase in actual business inventories, just a slower pace of inventory depletion that doesn’t add to industrial activity, real growth, or higher employment.

Instead, domestic consumption and real business investment, that together indicate the pulse of the economy, rose by merely 1.8 percent. And, much of this has been fuelled by government money and Federal stimulus.

The “official” unemployment rate is at 10 percent and likely to be reported higher in the next month or two. Counting part-timers looking for full-time employment and those too discouraged to continue looking, the “actual” unemployment rate is probably close to 20 percent.

Those of us still employed are increasingly anxious that we may soon join our unemployed neighbors while our personal net worth has fallen sharply with home prices and the stock market. As a result, the savings rate is rising – and Americans are spending less. This is not a picture that suggests personal consumption, which typically accounts for two-thirds of GDP, will be sufficient to trigger a virtuous circle of spending, business activity, employment, increased tax revenues, and a naturally decreasing Federal budget deficit.

Monetary and fiscal policy – typified by quantitative easing and a rapidly expanding monetary base, along with various “stimulus” programs that do little to improve our national infrastructure or international competitiveness – are inflationary and will debase our currency’s purchasing power regardless of the exchange rate with the euro or other key currencies.

In fact, it only takes a trip to the grocery store to realize that inflation is much higher than the monthly consumer and producer price data suggest. Recent month-to-month data has been skewed downward by faulty seasonal adjustments, but on a year-over-year basis, the December consumer price index rose by 2.7 percent and the producer price index rose by 4.4 percent. And, even these numbers underestimate actual inflation due to the depressed imputed rental cost of housing and other adjustments to the data.

Economists at the Fed and within the Administration base their policy judgments on the core rate of inflation, which excludes food and energy. Because these are just the two sectors where inflation is most likely to manifest, policy will inadvertently have an inherent inflationary bias.

Policymakers are also missing the coming inflationary impulse from abroad via the continuing raise in commodity prices. China, India, and other emerging economies that are leading the world recovery are committed to industrial and infrastructure development, and have rapidly growing middle classes demanding improved diets, more automobiles, better highways, bigger homes with dependable electricity and household appliances. The likely outcome is rising global demand and much higher prices for key commodities.

Against this economic backdrop – especially the inability of America to deal effectively with our economic problems, more of the same from economic policymakers, and the inevitable rise in U.S. inflation rates – it is only a matter of time before the dollar’s appeal diminishes and gold regains its status as the ultimate safe haven.