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How Monetary Policy, Debt & Inflation will Affect the Price of Gold and Silver

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How Monetary Policy, Interest Rates, Debt & Inflation will Affect the Price of Gold & Silver

 

The banking crisis of 2023 was the catalyst for stronger demand and higher prices in the gold and silver markets. Based on who you speak with, some people believe that this is a one-time event while others believe that it’s the beginning of a sustained bull run in precious metals. Of course, everyone that follows the sector has an opinion one way or the other. 

Historically, there’s always been a catalyst that has resulted in the beginning of a bull or bear market. Take Lehman Brothers for example.

Lehman Brothers, one of the oldest and well-known investment banks in the world filed for bankruptcy in September of 2008, which triggered the subprime mortgage crisis and subsequently resulted in the collapse of the economy and stock market. With a bubble in the stock market and an economy that was structurally weak, something eventually was going to cause the bubble to burst.

While the banking crisis may have been the catalyst for strong demand and higher prices in the precious metals market, this is only the tip of the iceberg, and is far from the only driver for anticipated continued strength in the sector. While we can think of many reasons why we expect to see gold and silver perform well in the foreseeable future, for the purposes of this article, we’re going to primarily focus on monetary policy, interest rates, debt and inflation.

You may be familiar with some of these factors, but considering we’re seeing a number of new developments both globally and domestically, we hope that we’ll be able to share some thoughts and insight that may help shed some additional light on the current situation.

With that being said, we’re going to begin our discussion with Federal Reserve Monetary policy.

Federal Reserve Monetary Policy

The Federal Reserve is a private bank that was established in 1913 and is responsible for controlling the monetary policy of the United States. What exactly does monetary policy mean? Monetary policy is a fancy term for the amount of money in circulation. For example, if the Federal Reserve is trying to stimulate the economy due to slow growth, which typically occurs during a recession, they’ll effectively “print money” to help generate lending activity. Of course, these days they just electronically add digits to their balance sheet as opposed to physically printing money.

They do this by buying government bonds, which helps to reduce interest rates. Of course, in recent years, they’ve expanded their purchases beyond government bonds to include mortgage-backed securities (MBS) and corporate bonds. Historically, cheap money, or artificially manipulated interest rates, has bolstered demand for lending and credit, which results in more business activity, including building, new business startups, business expansion, a strong housing market, etc.

On the other hand, when inflation is running hot (historically the Fed has had a 2% inflation target), and the Fed wants to rein in inflation, they withdraw liquidity from the system.

They do this by selling bonds into the bond market. The more bonds available in the market tends to push interest rates up and makes it less attractive for entrepreneurs, businesses and potential home buyers to secure financing.

At present, which may differ by the time you read this article, the Federal Reserve has been pursuing a tight monetary policy. They have been reducing their balance sheet by selling bonds and by increasing the Federal Funds Rate. What is the Federal Funds Rate? It’s the overnight rate at which banks loan money to each other to meet liquidity requirements. While this doesn’t sound like it should have any affect on the rest of the economy, the Federal Funds rate indirectly affects the price of mortgage rates, credit card rates, auto loans, and commercial loans, just to name a few.

It also incentivizes banks to park their excess reserves at the Fed at a significant interest rate. At present, the Fed is paying 4.9% to banks on excess reserves deposited with the Fed. If banks are concerned about the ability of individuals or businesses to make good on their loan payments, they can mitigate this risk by choosing not to lend and receive a risk-free guaranteed rate of approximately 5%.

Not surprisingly, we’re starting to see weakness in the commercial and residential housing sectors with the recent increase in mortgage rates. When a $500,000 home can be purchased with a 30 year mortgage with a rate of 3%, as was the case a year ago, your estimated monthly payment is around $2,000. However, with current rates at 7%, that increases your monthly payment to over $3,000, which makes it unaffordable for most middle-class Americans.

How Monetary Policy Affects Gold & Silver Prices

We’ve talked a little bit about how lending and real estate is affected by higher rates, but how does Federal Reserve monetary policy affect gold and silver prices?

Historically, tighter monetary policy has resulted in lower gold and silver prices, as higher interest rates increase the strength of the dollar. This makes sense because there’s less liquidity sloshing around in the system.M2 Money Supply Chart

Furthermore, higher interest rates incentivize people to save – especially if they’re able to obtain a positive inflation-adjusted return.

On the other hand, a loose monetary policy means that more money has been created without a corresponding increase in goods and services. More money chasing a fixed number of goods and services is monetary inflation and generally results in price inflation, which is what we’re all experiencing at the grocery store and at the gas pump. This expansion of the monetary base weakens the dollar (remember, more dollars are created out of thin air).

Since gold and silver are seen as a hedge against a weakening dollar or high inflation, they tend to perform well in these environments. Considering that the Federal Reserve has increased interest rates from 0% in March 2022 to 5% – 5.25% at present, and the “official” inflation rate has dropped from a peak of 9.1% in June 2022 to 5%, you would expect for gold and silver prices to have fallen over the past year. While we saw a brief dip into the $1,600’s in September and October, gold finished the year in positive territory and has been on a terror ever since.

Keep in mind that the strong performance of gold and silver has been in spite of a tighter Federal Reserve monetary policy, which should in theory have caused prices to pull back. Of course, the Federal Reserve may continue to increase interest rates from here, with an estimated terminal rate in the 5.5% – 6% range. In other words, it’s believed that a relatively small increase in interest rates from present should cause inflation to continue to drop with the expectation that it will revert to the Fed’s target rate of 2%.

Between a Rock and a Hard Place

One thing to always remember is that monetary policy is a double-edged sword. If the Fed continues to increase interest rates and withdraw liquidity from the system, it will contribute to an economic slowdown. We’re already seeing weakness in the commercial and residential sectors, not to mention an increase in the filing of corporate bankruptcies.

Federal Reserve Rock and Hard Place Monetary Policy

In fact, 70 major companies filed for bankruptcy during the first quarter of 2023, which is on par with the number of business closures we saw during the Great Recession of 2008 – 2009. This is clearly an indication that consumers are tightening their belts.

Furthermore, we’re seeing an increase in the filing of unemployment benefits and weakness in the jobs market. You only need to scratch the surface of the headline jobs report to realize that things aren’t as they seem. The additional jobs being created are primarily government jobs or are in the service sector. Of course, government jobs don’t add any real benefit to the economy and most service sector jobs are typically low paying and oftentimes part time jobs. Of course, the service sector will be one of the first sectors to feel the pain of a slowing economy, as fewer people will have discretionary income to spend on activities such as travel, hotels, movies, restaurants, etc.

If the Federal Reserve is hoping for a “soft landing,” which means a slowing of the economy enough to tame inflation, but to not cause a recession, they’re quickly running out of runway. In other words, their capacity to continue to increase interest rates appears to be limited.

Debt, Deficits and Debt Servicing Costs

Our discussion thus far has been on the monetary side, but we haven’t touched yet on the fiscal side, which is a ticking time bomb. What do we mean by fiscal policy? To put it simply, this is the government’s ability to properly budget. In other words, spend less than they receive in revenue in the form of taxes. For those individuals that have been keeping score, we’ve been running annual deficits of more than $1 trillion per year since 2020 and are projected to do so for the foreseeable future. This means that the federal government is spending in excess of $1 trillion per year above and beyond what they collect in taxes. This is approximately 20% more than their annual revenue.

Fiscal irresponsibility has catapulted our national debt to nearly $32 trillion. With a gross domestic product (GDP) in 2022 of roughly $25 trillion, this puts our GDP to debt ratio of around 128%, which is banana republic territory. For those folks not familiar with the term GDP, it’s basically the market value for all goods and services produced during the year, or in other words, the country’s output. There aren’t too many countries that can spend more than they produce and continue to be viable in the global economy.

As a nation, we’ve been extremely fortunate that interest rates have been so low, which has enabled us to continue to service our debt. Interest payments on national debt in 2022 were $475 billion, which is the seventh largest government expenditure behind Social Security, Medicare, Medicare, and Defense. If we ended 2022 with national debt of $31.4, this means that we had an average debt servicing interest rate of approximately 1.5%. Low interest rates have enabled us to spend well beyond our means with limited consequences until now.

If we look at the current federal government debt yield curve, we see two troubling factors, The first is the much higher interest rates for all government bonds, ranging from 3 month treasury bills to 30 year bonds.

The lowest yield or interest rate at the time of this writing is the 10-year rate at 3.57%, which is nearly 2.5 times the average interest rate that we paid in 2022. The highest current yield is 5.14% on 3 month government treasury bills. While not all the government debt will be rolling over this year, eventually the debt is going to have to be refinanced, which will likely be at much higher rates. If we eventually refinance our debt at an average interest rate of 5%, which is more in line with the historical average, this would more than triple our debt servicing costs. It would also make interest payments on debt the single largest line item in the government’s budget and account for nearly one-third of tax revenues.

Yield Curve chart 5.12.23
Yield Curve Chart 5.12.23

The challenge of course is that if the federal government continues to run $1 trillion deficits and foreign central banks continue to liquidate their U.S. treasury holdings, there will be a limited number of buyers for our government debt. Fewer buyers will translate into higher interest rates, which makes sense, as investors need to be compensated for the additional risk they assume when purchasing government bonds from a highly indebted nation.

These higher interest rates will make it more difficult for the government to service their debt, leaving the Federal Reserve to pick up the slack. If the Federal Reserve “pivots,” which means that they shift from a tight monetary policy to a loose monetary policy by buying government bonds to prevent interest rates from getting out of control, this will weaken the dollar and result in monetary inflation and possibly price inflation. If they do this before they’re able to get inflation under control, we can expect to see double digit inflation in the years to come. Many financial experts are predicting “stagflation,” which is the worst of both worlds. Stagflation is defined by high inflation, high unemployment and little to no growth.

Future Direction of Gold & Silver

When viewed from the lens of gold and silver, we can expect prices to continue to increase over the long term.

Sure, there will be times when investors will take profits off the table causing prices to consolidate, but the long-term trajectory is positive. Keep in mind that gold and silver prices have been performing well under a scenario when you would expect the opposite to occur. If you take the governor off the wheels, which is effectively what the Federal Reserve would do by shifting policies, we expect to see new highs reached in gold and silver prices in the not-too-distant future.

None of what we covered today includes other potential catalysts that can cause an explosion in gold and silver prices, such as the formation of aBRICS Nations monetary policy commodity backed BRICS currency, rumors of a gold backed Chinese yuan, legislation proposed in the U.S. Congress to adopt a gold-backed currency, and proposed legislation in Texas for a gold-backed digital currency, just to name a few. All the while, countries in the East have been adding to the gold holdings in recent years with Russia, Turkey, China and India accounting for the largest buyers. Incidentally, these are also all countries that are rumored to adopt a BRICS currency, which will likely be commodity backed.

We’ll discuss some of these recent developments in a future piece, but the important take away from today’s article is that the current and future expected monetary and fiscal policies of the Federal Reserve and U.S. government are bullish for gold and silver. While our discussion has been focused on gold, the price of silver tends to follow suit.

This website provides a year-by-year gold to silver ratio, which shows on average that the gold to silver ratio has been in the range of 60 to 1. The lows were around 16 to 1 while the highs were around 126 to 1 when Covid hit in March of 2020. If we take into consideration the historical gold to silver ratio, it’s safe to say that gold won’t dramatically outpace silver even if the U.S., a foreign nation or a group of nations adopt a gold standard.

Let’s assume for the purposes of discussion that the U.S. went back on the gold standard. With $31.7 trillion in debt and 248 million ounces in U.S. gold reserves, we would be looking at a gold price of $127,822. This is assuming that every dollar of debt was backed by gold. However, if we adopted a 40% ratio, which is similar to what it was in the past, the gold price would be $51,128 an ounce. If silver followed suit at a 60 to 1 ratio, it would be $852 per ounce at a 40% coverage ratio. This would result in gold and silver prices increasing from current levels by approximately 25 and 35 times, respectively.

The above of course assumes that we actually have 248 million ounces in gold reserves. Many questions abound as to the United States’ actual gold holdings, as the gold reserves at Fort Knox haven’t been audited since 1953.Gold Reserves by Country as of 2022

Proposed bills over the years to audit the Fed and our gold reserves haven’t been passed, which causes further speculation and questions. At the end of the day, we’re not making any specific predictions on the future price of gold and silver; we’re just sharing with you what the numbers bear out.

Summary

We covered a lot of ground today, so let’s recap.

At present, the Federal Reserve is pursuing a tight monetary policy, which historically has caused a major headwind to gold and silver prices. However, precious metals continue to perform well in an environment that’s far from ideal for precious metals. This likely is in response to a banking crisis, but there are many other potential black swans that can cause prices to rise even further.

gold price explodes

The Federal Reserve is damned if they do, damned if they don’t. If they continue to raise interest rates and withdraw liquidity from the system, it will cause debt servicing costs to rise above acceptable levels. Furthermore, it will plunge an already weak economy into a severe recession. If they pivot and adopt a loose monetary policy, inflation rates may run out of control making it nearly impossible to rein in. Not to mention, it will weaken the dollar and cause foreign countries to speed up their de-dollarization process.

While the Federal Reserve is the main culprit, the federal government shoulders just as much of the blame. If as a nation we were fiscally responsible and operated within a balanced budget, or even a surplus, we wouldn’t need the Federal Reserve to intervene in the economy as they have in recent years. At the pace we’re going, debt servicing costs will soon become the largest line item on the U.S. government’s budget.

While none of the above policies are ultimately good for America, they’re positive for precious metals, most notably gold and silver.

The adoption of a gold backed currency by the U.S., a country with substantial gold reserves, or by the BRICS nations, will cause prices to shoot to the moon. Gold and silver stackers will finally have their day in the sun. While we may not reach six figures in the price of gold, look for significantly higher prices from current levels.

The gold and silver experts at Atlanta Gold & Coin Buyers are here to help. We monitor fiscal and monetary policies as well as geopolitical issues that may affect gold and silver prices. With years of experience in the industry, we can recommend the best products to meet your long-term needs.

Reach out to us today at 404-236-9744 to see why we’re the premier gold and silver dealer in metro Atlanta and beyond.

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Tony Davis
Tony Davis is the owner of Atlanta Gold & Coin Buyers, a full service Atlanta based coin and bullion dealer specializing in buying, selling and appraising coins and coin collections of all types and sizes. Tony frequently writes on various economic and numismatic related topics affecting the coin and bullion markets and has been published on some of the industry’s leading websites, including Coin Week, the American Numismatic Association, Coin Collector, Coinflation, and Coin Auctions Help, just to name a few. Visit Atlanta Gold & Coin’s website at atlantagoldandcoin.com to obtain additional information on the products, services and educational resources offered by his company. Tony can be reached at sales@atlantagoldandcoin.com or at 404-236-9744

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