Even Volcker couldn’t “Volcker” in today’s economic conditions
We have discussed policy – especially monetary policy often recently.
This is because currency values are directly impacted by policy, and gold is a currency, therefore, is directly impacted by the policy.
Although it is arguably changing, the U.S. dollar is still the ‘reserve currency’, a large percentage of trade, and most commodities are still priced in U.S. dollars.
This keeps the Federal Reserve’s (Fed) actions important to the gold market.
We discussed the Fed’s March 15-16 meeting and Chair Powell’s press conference in our post The Fed Has No Idea What’s Coming Next! In that post, we discussed the updated Fed outlook for rates is much higher than in December.
This week Chair Powell spoke in Washington DC at the National Association for Business Economic meeting. He reaffirmed his previous statement that the Fed could raise rates as fast as Volcker did back in the late 1970s-early 1980s.
And went on to reaffirm that the Fed could raise rates past the ‘neutral rate’.
The neutral rate is defined by the Federal Reserve of Dallas as: The neutral rate is the theoretical federal funds rate at which the stance of Federal Reserve monetary policy is neither accommodative nor restrictive.
It is the short-term real interest rate consistent with the economy maintaining full employment with associated price stability.
History tells us that when the Fed raises rates to the neutral rate that it soon must rapidly cut rates because an economic recession is on the horizon or has already taken hold.
The Volcker Shock
This most recent Powell speech deliberately invokes the Fed’s greatest triumph of decades past and the comparison implies the current Fed could once again ‘Volcker’ interest rates. On this point, we start with a short recap on the ‘Volcker shock’.
Paul Volcker was the Fed Chair from 1979 to 1987 and is known for rapidly raising interest rates starting in the late 1970s to combat high inflation.
Moreover, by 1980 the fed funds rate was at 20%, the highest in history. Also, Volcker kept the fed funds rate above 15% until mid-1981.
Also, this rapid and prolonged rise in interest rates became known as the “Volcker shock”.
The rapid increase in interest rates did indeed lower inflation but also caused back-to-back recessions in the early 1980s.
Also, the Volcker shock worked in the early 1980s. This was to end high inflation under a very different economic environment than exists today.
First, the 1970s high inflation largely did the decision by then President Nixon to close the gold window in early 1970, after which the U.S. dollar plummeted.
To try and stop the rising inflation Nixon implemented wage controls. This made the situation worse and turned the problem into stagflation. High inflation with low economic growth due to restricted business activity.
The Fed Chair in the early 1970s Alfred Hayes was faced with trying to fight off inflation while maintaining growth – and raised and lowered the fed fund rates in cycles.
Moreover, this only added to the inflation problems as consumers tried to purchase ahead of interest rate increases.
The increased demand pushed prices higher until Volcker became Fed Chair. It was clear that he would continue to increase interest rates until this demand was stifled.
What Happens Now?
In today’s environment, the high inflation is largely due to supply shortages. This was exasperated by the Russia/Ukraine war and the disruption of commodities that are produced in Russia.
Also, this brings us to our second point. Even Paul Volcker couldn’t today raise interest rates as high past the rate of inflation as he did in the early 1980s.
The main reason is high government debt.
Volcker himself addressed concerns about rising government debt in a 2016 op-ed in the New York Times. It was co-authored with Peter Peterson titled “Ignoring the Debt Problem”.
Here is an excerpt:
Our current debt may be manageable at a time of unprecedentedly low interest rates.
But if we let our debt grow, and interest rates normalize, the interest burden alone would choke our budget and squeeze out other essential spending.
There would be no room for the infrastructure programs and the defense rebuilding that today have wide support.”
Volcker and Peterson go on to say:
“It’s not just federal spending that would be squeezed.
The projected rise in federal deficits would compete for funds in our capital markets and far outrun the private sector’s capacity to save, to finance industry and home purchases, and to invest abroad.
Instead, we’d be dependent on foreign investors’ acquiring most of our debt — making the government dependent on the “kindness of strangers” who may not be so kind as the I.O.U.s mount up.”
And who amongst the international community is going to buy this U.S. debt. Japan is the largest international holder, so maybe them.
What about other large buyers, the second largest in China which is highly doubtful since China is trying to de-dollarize.
As we have stated before the Fed is indeed between a rock and a hard place. However, a hardline increase in interest rates past the rate of inflation is unlikely in the current deck of cards, which is positive for gold and silver.
From The Trading Desk
All focus is currently on the bond markets as the federal reserve start to tighten and raise rates for the first time since 2018.
The latest rise in bond yields was blamed on market concerns around the Fed’s hawkish monetary policy tightening stance.
On Monday, Powell stated that inflation is ‘much too high’ and 50 basis point rate hikes are now possible which the market is starting to price in for May.
Powell went on to say
‘If we conclude that it is appropriate to move more aggressively by raising the federal funds rate by more than 25 basis points at a meeting or meetings, we will do so’.
Goldman Sachs on the back of Powell’s speech have revised their outlook and are now projecting two 50 basis point rate hikes at the May and June meetings.
Given the rising bond yields and the stronger USD which would put pressure on the gold price, gold has stayed above the crucial $1,900 support area and moved back to settle near $1,950 this morning.
The key driver we are seeing currently for clients looking to invest in physical gold is inflation fears, slower economic growth, and the increased demand for safe havens.
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GOLD PRICES (USD, GBP & EUR – AM/ PM LBMA Fix)
23-03-2022 1932.15 1931.75 1461.09 1463.69 1756.32 1759.63
22-03-2022 1929.35 1915.25 1461.48 1445.44 1753.97 1735.98
21-03-2022 1925.05 1935.05 1464.96 1465.61 1742.17 1751.80
18-03-2022 1932.90 1935.80 1470.74 1471.60 1749.27 1754.42
17-03-2022 1941.40 1949.65 1473.13 1485.63 1759.10 1759.17
16-03-2022 1918.75 1913.20 1468.42 1460.15 1744.53 1736.42
15-03-2022 1928.75 1913.65 1479.16 1464.13 1754.01 1742.19
14-03-2022 1961.60 1954.05 1503.96 1496.02 1788.19 1782.48
11-03-2022 1991.45 1978.70 1521.27 1512.72 1813.22 1803.19
10-03-2022 1997.65 1996.60 1518.61 1520.41 1810.27 1812.51
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