Low inflation is frustrating for central bankers.
The reason? They can’t lower interest rates much below zero as long as investors have the option of withdrawing cash and putting it in the “Bank of Sealy Posturepedic.”
And if inflation is near zero and interest rates are already at zero, then central banks can’t stimulate the economy by lowering the cost of borrowing. Thus, believers in stimulus – which includes most central bankers these days – are frustrated by this zero lower bound.
Recently, U.S. consumer price inflation came in at zero for the 12-month period ended September 30, 2015.
That figure is a product of the halving in oil prices in the last 12 months. However, the “core” inflation figure is 1.9%, and there are some markets, such as housing, where the official figure of 3.2% inflation may seriously understate the true figure.
On top of that, the oil price drop won’t be repeated, since they’re not going to start giving the stuff away. So reported inflation will trend upwards regardless of what happens elsewhere.
Not surprisingly, then, gold has shown strength in the last couple of weeks – though inflation isn’t the only catalyst.
There’s another factor, namely a bizarre new proposal from Bank of England Chief Economist Andy Haldane that’s catching on with Fed governors and frustrated central bankers worldwide.
You see, if Haldane gets his way, gold may not just be a store of value – it may be the only one left.
Haldane’s solution is to abolish cash.
For its part, Britain has moved further toward electronic payments than the United States. Checks are already eccentric there. Thus, cash abolition may be feasible.
Everybody would have bank accounts, and all payments, no matter the size, would be undertaken with debit or credit cards (which could themselves be loaded with value at an ATM).
Once everything is electronic, the zero lower bound could be eliminated, and central bankers could set the short-term interest rate at minus 5% if they so desired.
No wonder the gold buyers are quietly accumulating.
It’s unlikely that Haldane floated this trial balloon without the approval of his boss, Bank of England Governor Mark Carney. Thus, central bankers are thinking about this proposal at the top level.
However, Britain couldn’t abolish cash by itself without re-introducing exchange controls, which were removed in 1979. At this point, British citizens could simply hold their cash balances in dollars, euros, or renminbi instead. Thus, the crucial players would be the euro zone and the United States.
Given the attitude of the Federal Open Market Committee members, who apparently support keeping interest rates at zero into 2016 (and for who knows how much longer), the Federal Reserve might also support cash abolition.
Plus, if rates are still at zero when the next recession hits, the pressure to do something beyond another ineffectual dose of “quantitative easing” would be immense. At that point, cash abolition might look attractive to, say, President Hillary Clinton, if she were beset by a 2017 recession.
Once cash had been abolished, the Fed could set interest rates as far into the negatives as it liked, and investors would either suffer massive erosion of capital or be forced to buy overpriced stocks, real estate, or bonds carrying negative interest rates.
Other than a giant asset bubble (developers could make money by borrowing at, say, minus 2% and investing in empty office buildings), it’s not clear what effect minus 5% interest rates would have. In terms of asset prices, they would almost certainly be inflationary, at least in the short term.
In terms of consumer prices, they might well be deflationary. Arbitrage would cause a currency with minus 5% interest rates to rise 5% per annum against any fortunate neighbors that still had cash and positive interest rates, which in turn would cause domestic prices to decline by 5% per annum over time.
Of course, 5% per annum price declines would cause the whole scheme to collapse in a rash of huge bankruptcies.
And that’s where gold comes in.
Break Out the Shovels
Gold is a store of value that governments can’t abolish.
They can make it illegal for you to hold gold, as President Roosevelt did in 1933 (the prohibition lasted until 1974). But the gold market would then just go underground, probably literally – people would bury their gold hoards in the back garden, as Samuel Pepys did during the Great Fire of 1666.
Gold would be accepted internationally, and its return of zero minus a few holding costs would be highly competitive against abolished-cash currencies at minus 5%.
This is why gold has been strong recently.
Even a small possibility of cash abolition should make you want to stash as much as possible into physical gold – not gold ETFs or gold mines, but the metal itself. Investors the world over are beginning to take gold seriously again, which itself will cause a price surge and massive additional buying.
Bottom line: Maybe this trend will reverse. But in the short term, unless the Fed raises interest rates, that’s not the way I’d bet.