The Fed Is Officially Insane

There’s an old saying that defines insanity as doing the same thing over and over again and expecting different results. The Federal Reserve wants to test that theory.

Fed officials have been all over the media for weeks, laying the groundwork for a third round of quantitative easing. By preparing markets for QE3, the Fed refuses to let real-world evidence get in the way of its beloved theories. QE operations haven’t worked; they’ve just promoted government spending and higher savings rates to make up for low interest rates.

The arrogance and groupthink among Federal Reserve officials won’t allow them to diagnose the following: The Fed, by its radical actions, mutates the very economy it’s trying to “boost.”

An honest review of the Fed’s record would conclude that it’s rotten. In a recent update of The Speculative Investor, Steve Saville explains why the whole concept of central banking is “rotten to the core.” He describes how central banks are providers of gambling insurance to the banking system:

“[The] central bank offers the equivalent of gambling insurance to the banking industry.

“Imagine if an insurance company made the following deal with all patrons of a casino: In exchange for a patron’s promise to gamble prudently, the insurance company promises to come to the patron’s aid if he finds himself short of money. Knowing that the insurance company was essentially acting as a financial backstop, at least a few gamblers would take more risk than they would otherwise.

“In a similar vein, knowing that the central bank will be ready, willing and able to provide support via emergence liquidity injections if things go wrong, some private banks will take more risks. Furthermore, due to the higher profits that tend to temporarily accrue to the banks that take more risk, most banks will eventually be drawn toward riskier business practices. This is why a mechanism supposedly (according to the propaganda) put in place to prevent banking crises ends up increasing the severity and frequency of banking crises.”

It’s no mystery why the US banking system had built up reckless lending and securitizing practices in the years leading up to the 2008 financial crisis: Reckless behavior paid well.

Now, instead of enabling reckless bank lending, the Fed (and other central banks) is enabling the addiction of governments to easy borrowing terms. It’s now providing gambling insurance to the biggest spending addicts in history: the US government. Suppressing interest rates near zero for years and years will transfer countless wealth from savers to the government budget.

As budget deficits continue to be measured in the trillions, we will see the size of central bank balance sheets grow too. Inflation will remain stubbornly high worldwide, despite sluggish economic activity. Central bankers may talk tough from time to time, but they will ultimately do the bidding of governments — and print.

For years, I’ve expected that at the end of all this central bank printing, we’ll see the end — not a reversal — of quantitative easing programs and a re-pegging of the US dollar to gold at much higher gold prices. A new gold standard would allow the Fed and other central banks to save face after the following sequence of events:

1. Central banks inflate their balance sheets and buy up many of the bonds governments issue to fund soaring budget deficits

2. Once the largest suppliers of scarce products realize they’re exchanging products for infinitely diluted paper money, they start demanding more and more money in exchange for sending their scarce products to the marketplace

3. Consumer prices start rising

4. Calls for monetary tightening (reduction of central bank balance sheets and interest rate hikes) grow louder

5. These central banks won’t be able to slash money supplies without crashing government bond markets and stock markets. They talk about tightening, but don’t tighten

6. As central banks lose credibility, gold launches on a final, near-vertical stage of its bull market

7. In response to inflation expectations running wild, governments and central banks draw up plans to re-peg currencies to gold in order to avoid having to drain trillions worth of cash from the banking system.

It’s almost impossible to imagine the Fed managing a “soft landing” back to its pre-quantitative easing condition. I compare QE operations to a roach motel: easy to enter and impossible to exit in a practical manner.

Say that the Fed doubles the size of its balance sheet yet again over the course of a QE3 operation, while the market’s expectation of future inflation steadily rises. The selling pressure on Treasuries would steadily grow, undermining the value of the Treasuries already sitting on the Fed’s balance sheet. On a mark-to-market basis, the equity on the Fed’s balance sheet would be negative — by several hundreds of billions of dollars.

How long will it take investors to realize this dilemma is incredibly bullish for gold? At the end of these money-printing operations, central banks won’t be able to sell assets and shrink money supplies gracefully — or at all.

Perhaps once the global paper money system is restructured, involving some sort of gold standard, sanity will return to the Fed and other central banks. Until we see more signs of sanity, hold a core position in gold, silver, and precious metal mining stocks. These asset classes will be the prime beneficiaries of future printing.

Regards,

Dan Amoss,

for The Daily Reckoning