When the Fed gave itself the ability to pay interest on bank reserves, it gave itself the ability to hike its targeted short-term interest rate (the Fed Funds rate) without tightening monetary conditions. In other words, it gave itself the ability to tighten monetary policy in the eyes of the world without actually tightening monetary policy. That’s one reason why it’s absurd that almost everyone involved in the financial markets is intensely focused on the timing of the Fed’s first 0.25% upward adjustment in the Funds Rate. It’s not only that a 0.25% increase is trivial, but also that, thanks to the payment of interest on bank reserves, it will almost certainly be implemented without making the monetary backdrop any less ‘accommodative’.

I’ve dealt with this topic a number of times at TSI, most recently last week. Here’s what I wrote last week under the heading “Why the Fed pays interest on bank reserves”:

“The Fed’s reason for paying interest on bank reserves has been addressed in previous TSI commentaries, but it’s an important issue and worthy of additional commentary space. That’s especially so because there is so much confusion surrounding the issue. In particular, the actual reason for the interest payments is at odds with the beliefs/assumptions of many journalists, newsletter writers and other commentators on financial matters.

Before getting to the real reason we’ll deal with the two most common false beliefs. The first of these is that the Fed started paying interest on bank reserves to prevent the commercial banks from rapidly expanding their loan books in reaction to the Fed-generated ballooning of reserves from Q4-2008 onwards. The second is that the main purpose of the interest payments is to provide financial support to the banks.

There is no truth to the first belief, because the interest payments on reserves have no effect on either the ability or the willingness of banks to make loans. The facts are that a) reserves cannot be loaned into the economy, b) there has been no relationship between US bank reserves and US bank lending for decades, and c) even if the amount of bank lending were influenced by the level of reserves as wrongly explained in outdated economics textbooks, an increase in a bank’s lending would not affect the amount of interest earned by the bank on its reserves. This last point is due to the fact that an increase in a bank’s loan book could shift reserves from the “excess” to the “required” category, but wouldn’t affect its total reserves. The Fed, however, pays interest on ALL reserves, not just “excess” reserves.

There is some truth to the second belief in that the payment of interest on reserves does provide some additional income to the banks. However, even with today’s massive reserve levels the financial impact on the banks is trivial (at the current interest rate we are talking about $6B/year of reserve-related interest payments across the entire banking industry, which is a veritable drop in the ocean).

The real reason that the Fed began paying interest on bank reserves in late-2008 was to enable it to maintain control of the Fed Funds Rate (the overnight interest rate on reserves in the inter-bank market and the primary rate targeted by Fed monetary policy) while it pumped huge volumes of dollars into the economy and into the reserve accounts of banks.

To further explain, prior to the extraordinary measures taken by the Fed in late-2008 in reaction to the global financial crisis, the Fed Funds Rate (FFR) could be adjusted by making small changes to reserves. However, after the Fed began pumping hundreds of billions of dollars of reserves into the banks, the central bank was in danger of losing its ability to control the FFR. With the commercial banks inundated with reserves and with plans in place for additional rapid monetary expansion, it became clear to the Fed that even maintaining an extremely low FFR of 0.25% was going to be impossible. Furthermore, the Fed was thinking ahead to the time when it would have to start hiking the FFR. With reserve levels way in excess of what they needed to be to set the FFR at 0.25%, even the superficially minor task of pushing the FFR back up to 0.50% would, under the Fed’s traditional way of operating, necessitate a large-enough contraction of bank reserves and the money supply to bring about another financial crisis.

Think of it this way: In October of 2008 the FFR was at 1% and the total level of US bank reserves was $315B. This suggests that $315B was consistent with an FFR of 1%. Today, the total level of bank reserves is about $2.5T. The implication is that to get the FFR back up to 1% the Fed would have to remove about $2.2T of covered money ($2.2T of money ‘backed’ by $2.2T of bank reserves) from the US economy, but there is no way that it could remove that amount without crashing the financial markets and the economy. Actually, we doubt that it could even remove a quarter of that sum without precipitating a stock market collapse and a severe recession.

This problem was obvious to Bernanke, and his solution was to pay interest on reserves. With this new tool in its kit the Fed gained the ability to set the FFR at whatever level it wanted without adjusting bank reserves and the economy-wide money supply. For example, if the Fed decides in the future that it wants the FFR at 1%, it could achieve this target by simply changing the interest rate on reserves to 1% while leaving reserve and money-supply quantities untouched.

A likely ramification of the Fed’s ability to control the FFR via the interest rate on bank reserves is that the Fed’s balance sheet has reached a permanently high plateau. There will be no traditional tightening of monetary policy in the foreseeable future.”

The Wall Street Journal recently broke the story that there is evidence of banks attempting to manipulate the prices of gold and other precious metals. In other breaking news, evidence has emerged that the Earth revolves around the sun, that the Pope is Catholic, and that bears sometimes defecate in the woods.

Kid Dynamite is happy that regulators are finally taking note, as he has studiously documented evidence of upward manipulation of the gold price for years, to seemingly no avail. Actually, what he has done is show that the same sorts of price/volume changes in the gold futures market that are routinely put forward to ‘prove’ downward manipulation can also be used to ‘prove’ upward manipulation. By carefully mining the data it is possible to validate almost any theory, even a ridiculous one.

In any case, my purpose in writing this post is not to delve into the murky world of gold-market manipulation theories, but to point out that “manipulation” is often a poorly chosen word. To manipulate is to skillfully influence or change to one’s advantage. As such, manipulation could be a legitimate business practice. In the financial markets, for example, there is generally nothing ethically wrong with a private (meaning: non-government) trader buying or selling with the aim of influencing the price. Trading with the express purpose of driving the price up or down will usually not lead to a profit, but one person’s reasons for buying or selling are not the business of anyone else.

“Manipulation” therefore doesn’t imply “wrong” or “unfair”. Other words must consequently be used to distinguish between the manipulation that could form part of legitimate business practice and the manipulation that involves a violation of property rights and/or a breach of fiduciary duty. Fraud is a good word. For example, if banks siphon money from their customers to themselves by front-running their customers’ orders or by misusing information given to them in confidence by their customers, as was alleged in a lawsuit filed by a jewellery firm last November, then the banks are engaging in fraud, not just manipulation.

Manipulation is not inherently wrong. Fraud, by definition, is.

Last year I noticed an article by Alasdair Macleod containing an estimate that China (meaning: China’s government) had accumulated 25,000 tonnes of gold between 1983 and 2002. I would say that this estimate was based on rank speculation, but that would be doing an injustice to rank speculation. It is more like total guesswork. It is largely based on assumptions that are either obviously wrong or that have no supporting evidence. I bring this up now because it looks like the 25,000-tonne figure that was plucked out of the air by Mr. Macleod last year is on its way to becoming an accepted fact in some quarters. For example, it forms the basis of a new estimate that China’s government now has 30,000 tonnes of gold.

Here’s the supply/demand table from Mr. Macleod’s article. The top section of the table purports to show the total amount of gold supply that was created during 1983-2002 and the bottom part of the table shows guesses on how this supply was distributed around the world. If the top section contains figures that are either based on false logic or completely lacking in evidentiary support, which is definitely the case, then the figures in the bottom section are irrelevant. That’s because the figures in the bottom section have been chosen so that they add up to the figures in the top section.

The most obvious error is the assumption that because gold was in a secular bearish trend during 1983-2002, there was no net buying of gold within the Western world over this entire period. Instead, it is assumed that not a single ounce of the 42,000 tonnes of gold that was produced by the global mining industry during this period was bought by anyone in Europe or North America. It is also assumed that the “West” reduced its collective gold holdings by 15,000 tonnes during the period.

This takes me back to a point I’ve made many times in the past in relation to similar misguided analyses of the gold market. The point is that the quantity of gold (or anything else, for that matter) transferred from sellers to buyers says nothing about price. The corollary is that price says nothing about how much was transferred.

The fact that the price of gold was making lower-highs and lower-lows during 1983-2002 does not imply that less gold was bought in the “West”. In fact, it’s just as likely that the opposite was the case — that sellers, including gold miners, had to lower their asking prices to account for the reduced eagerness to own gold and sell what they wanted to sell. It’s therefore quite possible that there was no net “Western” divestment of gold and that all of the gold produced during 1983-2002 was sold in the “West”.

I’m not claiming that all of the gold produced by the mining industry during 1983-2002 was sold to Western buyers, but such a claim would be no more ridiculous than Mr. Macleod’s guess that none of the newly mined gold was sold to Western buyers.

I’ll end this discussion by reiterating that even if you have enough information to do the additions accurately (which nobody ever will, by the way), there is no point adding up the amounts of gold being transferred between sellers and buyers in different geographical regions or different parts of the market. At least, there’s no point if explanations of past price movements and clues regarding future price movements are what you want. There could, however, be a point if your aim is to find a justification for being bullish no matter what’s happening in the world.

I should probably do a separate blog post titled “Total guesswork regarding China’s gold strategy”.

This post is a slightly-modified excerpt from a recent TSI commentary.

Gold tends to fare relatively poorly during the booms, which are periods when confidence in central banks and the economy rises at the same time as mal-investment is setting the stage for a future period of great hardship, and fare relatively well during the busts, which are periods when the investing mistakes of the past come to the fore. Be aware, though, that the word “relatively” is critical to understanding gold’s relationship to the boom/bust cycle, because the relationship often doesn’t apply to gold’s performance in US$ terms.

To show what I mean I’ll begin with a chart of the US$ gold price covering the past 20 years. There were booms and busts during this period that are not evident on this chart. In particular, 2001-2011 contained huge booms and busts, and yet the gold price trended steadily upward throughout. How could this be?

Armed with the 20/20 vision called hindsight, analysts who did not expect the large 2001-2011 rise in the US$ gold price and who were completely baffled by it while it was happening eventually came up with explanations/rationalisations for it. Some of the most popular explanations involved identifying other things that trended relentlessly upward during the 2001-2011 period and assuming that the rise in this other ‘thing’ caused the rise in the gold price.

For one example, prior to the past two years it was possible to create a chart that demonstrated a strong positive correlation between the gold price and the US federal-debt/GDP ratio, provided that you started your chart in the early-2000s (starting the chart much earlier would reveal that there was actually no consistent relationship between gold and the debt-GDP ratio*). For a second example, prior to the past two years it was also possible to create a chart that demonstrated a strong positive correlation between the gold price and the US Monetary Base, again provided that you started your chart in the early-2000s (as is the case with the supposed relationship between the gold price and the debt/GDP ratio, the relationship between gold and the US Monetary Base disappears when a longer-term view is taken**). For a third example, some analysts belatedly linked the 2001-2011 upward trend and subsequent downward reversal in the gold price to the goings-on in the “emerging” economies. This explanation is a top contender for the “grasping at straws” award, since, unlike the linking of gold to the debt/GDP ratio or the Monetary Base, it has absolutely no logical basis. Not only that, but the net buying of gold by India, China and Russia, the three most important “emerging” markets, was greater when the gold price was trending downward during 2012-2014 than when the gold price was trending upward during 2009-2011.

As intimated in the opening paragraph, the overarching driver of the gold price (the boom/bust cycle) only becomes clear when gold’s RELATIVE performance is viewed. More specifically, understanding why gold did what it did over a long period requires looking at how it performed relative to industrial metals.

The fact is that the gold market is generally weak relative to the industrial metals markets during the boom phase of the inflation-fueled, central-bank-sponsored boom/bust cycle and strong relative to the industrial metals markets during the bust phase of the cycle. In other words, the gold/GYX ratio (gold relative to the Industrial Metals Index) tends to fall during the booms and rise during the busts. This is due to gold’s historical role as a store of purchasing power and a hedge against uncertainty.

By shading the bust periods in grey, I’ve indicated the global booms and busts on the following chart of the gold/GYX ratio. During the 20-year period covered by this chart there were four busts: the multiple crises of 1997-1998 (the Asian financial crisis, the Russian debt default and the LTCM blowup), the recession of 2001-2002 that followed the bursting of the NASDAQ bubble, the global financial crisis and “great recession” of 2007-2009, and the euro-zone sovereign debt and banking crisis of 2011-2012. On a relative basis gold was clearly very strong during the busts and generally drifted lower during the intervening periods when confidence was rising.

Note that monetary-inflation-fueled booms tend to fall apart more quickly than they build up, which is why the rising trends in the gold/GYX ratio tend to be shorter and steeper than the falling trends.

When gold/GYX made a new multi-year low last October it indicated that the global boom was going to extend into 2015, which it has certainly done. However, gold/GYX’s sharp rise from its November-2014 low to its January-2015 high could be an early warning that the boom is on its last legs.

Gold/GYX has pulled back far enough from its January peak that a solid break above that peak would now be a clear signal that the boom has ended or is about to end.

*Refer to https://tsi-blog.com/2014/09/does-the-debtgdp-ratio-drive-the-gold-price/ for additional information

**Refer to https://tsi-blog.com/2014/10/does-the-monetary-base-drive-the-gold-price/ for additional information