Taper and Gold

The Fed’s taper began today, down $10 billion a month. I had grown to expect it in recent weeks even though previously I didn’t expect them to tighten. Gold fell $40 on the news.

In the longer term this is bullish for gold because higher interest rates will entice banks to lend more into the economy. At present the US banks have $2.5 trillion parked at the Fed earring 0.25% interest, or $6.5 billion. The bigger the interest rate differential on the Fed rate and commercial rates, the bigger the incentive to lend.

This 0.25% interest rate was introduced during the GFC to tide banks over a difficult time. The mega banks have taken advantage of it and have basically been getting a government subsidy on that money of 0.25%.

Normally banks have to keep some reserves with their central bank. This is the reserve part in “fractional reserve banking”. But while the Fed has been pumping up the money supply, the banks have been reluctant to lend. The Fed is responsible for about 15% of total money creation and velocity, while the banks are responsible for the other 85%. They have not been lending, so the money went to the Fed rather than sit on their books earning nothing. This is why the velocity of money flow through the US economy has been collapsing for the last five years, a fact I alluded to in my last post.

The Fed is now openly discussing the elimination of their 0.25% subsidy for the banks as their are a lot healthier now than a few years ago. This, combined with rising interest rates in the market due to tapering, will be THE catalyst to kick-start a reversal in the velocity of money in the US economy. When this happens, probably in the next half year, then we will finally see the conditions for a pick up in inflation.

This lack of inflation is why gold has suffered for over two years. The tide is finally turning.

God bless

Kevin

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