Game on for Inflation
You may be wondering why commodities, particularly gold and silver ramped after yesterday’s FOMC rate hike. In fact, maybe you’re wondering why gold and silver are still even traded, much less adding 6% and 9% respectively for the year. Doesn’t conventional economic wisdom state that; when the Fed is tightening, aka raising rates, this is removing money from the supply, therefore pushing up the value of the dollar and thus depressing all things inflationary – especially the mother of all inflation trades gold and silver? Isn’t this what is taught in all economic books in America and has been preached by esteemed advisers over the airwaves for the last several months? Did I lose you?
OK, let’s recap just a second. Why does one typically own gold or silver? Let me explain. Inflation, by basic definition results when goods and services rise in price. Typically, this is the result of a scarcity of supply combined with increasing demand. When UK plays Florida, the demand for tickets increases and therefore they are worth more. When UK plays someone that no one knows, and is expected to win by 50, the demand wanes and therefore ticket prices come down. In its purest form, this is how inflation works. When demand rises, prices rise. Now throw into the mix a small caveat; let’s say for a moment that, to avoid ticket prices going bonkers and pricing out the loyal fans, the University is able to create more seats at will. Poof, just like that. When a hot game comes to town, to help with the demand and keep prices in check, UK can just create more seats. This action would be similar to monetary policy from the Fed. By raising or lowering rates, it is able to slow down the prices of goods and services; i.e. inflation, or in some instances, spark inflation altogether.
Rather than create new seats to a ballgame, the Fed has the ability to infuse or retract money from the banking system in order to impact interest rates, which ultimately slows or promotes demand for expansion. When money is infused into the system, interest rates decline and demand for goods and services should increase. As demand increases, prices increase and inflation results. Conversely, when the Fed removes money from the system, thus raising interest rates, demand should slow and inflation decline. There are a multitude of ways to invest according to these maneuvers, the purest would be through gold and silver. Conventional wisdom says that when the fed is lowering rates, gold and silver should rise and when the fed is raising rates they should fall. So, why on earth are they ramping, and why have I been investing in silver these last several months? It’s really quite simple.
Let’s go back to our UK example. Let’s say that the hottest game is coming to town. Duke has brought Christian Laettner back to coach, and he is coming to Rupp with his undefeated Blue Devils to take on the undefeated Cats. Ticket prices are quite high, but they’re waffling a bit because the University hasn’t decided how many seats it will create for the game. Traditionally for this scenario, let’s assume the University would create 5,000 more seats. Because this is the hottest game in years, conventional wisdom says that UK will, more than likely, create even more seats than the traditional 5,000. Knowing this, scalpers and early ticket buyers set a price based on these assumptions While the prices are high, they’re not skyrocketing because these new seats will soon be available. The day arrives when the University is to announce its seat creation plan for the upcoming Duke game; rather than 7,000 or even the traditional 5,000 for whatever reason, it decides to create only an additional 1,000 seats. Within seconds, ticket prices soar.
You see, while the Fed is being diligent with its rising rate plan, attempting to pursue a path of prudent fiscal responsibility, the demand is such that it is already behind the curve. In fact, with the combination of a 2.7% rate of inflation* and 1% Fed Funds Rate, we are experiencing negative real interest rates. What this simply means is that, as the rate of inflation outpaces the amount they are receiving on their deposits, those sitting on the sidelines are losing money. How do folks hedge this? Well, it’s real simple. If you drop it on your foot and it hurts, it’s a tangible asset. Typically, those are the areas you want to be invested in during times of high rates of inflation. Thus, in this environment, I believe a partial allocation within gold and silver is critical for a well diversified portfolio.
Until next time
*2.70% is the annual CPI rate as of 2/28/17