How The Experts Were Wrong: Gold Failed To Hold $1,400 And The Taylor Rule

Robert Wagner

I’ve written many, many, many articles on how gold was being supported by a fundamental misunderstanding of monetary policy. The whole concept behind the myth is that printing money causes inflation. That belief is simply an outdated belief, but it is a very well entrenched belief. I wrote an article to try to explain why that is so, but better than that, I found a video of a top hedge fund manager confirming this concept. In the video, Anthony Scaramucci, Founder and Co-Managing Partner at SkyBridge Capital, explains how the experts running the hedge funds believed that flawed monetary model, and are now dumping their gold and SPDR Gold (GLD) because they are now recognizing their error.

The key point is that a top hedge fund manager is now pointing out to the markets that 1) they were following a flawed monetary model and 2) the other hedge fund managers that were following the flawed model have been making adjustments to their portfolios by selling gold. If the markets embrace the new understanding of monetary policy, it will almost certainly lead to more gold selling and a lowering of inflation expectations in their models. By the way, all this weakness in gold has occurred when central banks have been buying. The important point from that video is that central banks have been slowing the fall, and have not been able to reverse the price trend. Central banks aren’t in the business of losing money on their portfolios, and they aren’t into precious metal speculation, so I doubt that support will continue as gold continues lower. They simply would be better off buying the U.S. dollar.

In the above linked video, Anthony Scaramucci identified the “Taylor Rule” as the model the Fed follows, that the hedge fund managers failed to understand. That “rule” defines how the Fed operates, and sets the parameters for how the Fed manages monetary policy.

In order to investigate the practical application of such a policy rule, several years ago I proposed a specific formula for policy that had these characteristics. According to this policy rule the federal funds rate is increased or decreased according to what is happening to both real GDP and inflation. In particular, if real GDP rises one percent above potential GDP the federal funds rate should be raised, relative to the current inflation rate, by .5 percent. And if inflation rises by one percent above its target of 2 percent, then the federal funds rate should be raised by .5 percent relative to the inflation rate. When real GDP is equal to potential GDP and inflation is equal to its target of 2 percent, then the federal funds rate should remain at about 4 percent, which would imply a real interest rate of 2 percent on average.

It’s a pretty simple quantitative rule by which the Fed would set the target fed funds rate. The important aspect however isn’t the mechanics behind the rule, but its recognition of the Fed’s “dual mandate.” Contrary to popular and misguided opinion, the Fed cannot simply “print money out of thin air.” Yes, they do “print money out of thin air,” but it is not uncontrolled printing as the Fed critics and apparently the hedge fund managers believed. That last statement isn’t contradictory, much like we have the freedom of speech, but we can’t simply cry fire in a crowded theater. There are rules by which the Fed operates, so yes theoretically they could “print money out of thin air” until the cows come home and cause inflation like the critics feared, but practically they can’t.

Their “printing money out of thin air” is done within a broader framework. The Fed can only print money within a greater framework of full employment, low inflation and in a manner that fosters long-term growth. Like the governor on an old motorcycle engine, if the Fed ever did print enough money to generate inflation, it would be obligated to stop printing money and implement a strategy to contain inflation. That is the concept the gold buyers failed to grasp. The Fed controls inflation, they control printing of money, so unless the Fed chooses to ignore its mandate and the Taylor rule and get the man in charge fired, inflation is unlikely to occur. A bet on gold and for runaway inflation is a bet against the Fed, and it is a bet against the Fed when it is doing what it does best, that being fight inflation.

In conclusion, after a short-term rally, gold has failed to hold above the technically significant level of $1,400, and it appears gold owners are using any rally as an opportunity to exit their positions. Same appears to hold for silver and iShares Silver Trust (SLV). Immediately post-2008 crisis it is understandable that people feared uncertainty and were confused as to the direction of inflation. Today, however, is 5 years from then. There is a track record, and the markets have gained a new appreciation as to the effectiveness of modern monetary policy and the Taylor Rule. Old habits are hard to break, but as more and more participants in the market learn from the past 5 years, learn of the Fed’s duel mandate, learn of the Taylor Rule and work their new understanding of monetary policy into their models, the result will likely be to further lower their allocations to inflation hedges like gold and silver, and a reduction of their inflation estimates in their valuation models, which will result in higher estimates for their equity targets.


About abwehra group

The Art&Science of Trading Gold
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