August 7, 2006 - In November 2005 the Federal Reserve announced that it would no longer compile and report M3, which is the total quantity of dollars in circulation. I derided the Fed's decision, but my reaction to the consequences of it was mixed.
On the one hand, it was an important piece of anecdotal evidence confirming gold's bull market. As I wrote at the time in my article, "Coming in 2006 - Gold's New Record High" dated November 14, 2005:
"Maybe the Fed thinks this action will save the dollar from its inevitable collapse, but the reality is that it will hasten its demise…why would anyone hold dollars if they are unable to see how many dollars are being created to fund the soaring trade deficit and the federal government budget deficit, both of which by the way just hit record levels?
Information is important to maintain confidence in a currency. Without information, the only thing left is rhetoric, and who this day believes anything that comes out of governments and their agencies?
By eliminating its reporting of M3, the Fed is shooting itself in the foot. This misstep will only hasten the rush out of dollars into the safety and security of gold."
Gold was $468.30 ($15.06/gg) when I penned the above, so there has indeed been a rush out of the dollar into the safety and security of gold. But while the Fed's decision to discontinue M3 was revealing about gold's potential on one hand, on the other, there was an adverse consequence.
M3 is an essential component of my trusted Fear Index, which cannot be calculated without it. So while I accepted the Fed's decision as further confirmation that gold was in a bull market, I rued the fact that I would no longer be able to calculate and rely upon my Fear Index. Or maybe I still can?
I have been trying to create a pseudo-M3, but have not been successful. There is not sufficient data available because the Fed not only stopped reporting M3, but also some of the key components within it.
I also looked at using M2 as a substitute, but this result was unsatisfactory. Its differences from M3 are just too large. For example, before the Fed stopped reporting M3 in February 2005, M2 was growing at a much slower rate, 4.7% compared to the 8.1% annual growth in M3.
Another way of looking at their differences is to compare how M2 and M3 have diverged over the years. Even though M3 is calculated by adding just four other money components to M2, the relative share of M2 has become less important.
The Fed makes available reports of the money stock going back to January 1959. At that time M2 was 99.2% of M3. As of February 2006, M3's last reporting date, M2 was only 65.6% of M3. This stark divergence highlights how important these four money components within M3 have become. More to the point, this divergence also illustrates why M3 is the only accurate measure of the total quantity of dollars.
These four monetary components that are added to M2 to determine M3 are large time deposits, eurodollars, repurchase agreements, and institutional money market funds. The first three are no longer being reported by the Fed, which consequently makes M3 calculations impossible. It is I think revealing to note that these three components were growing at 23.2%, 15.5% and 7.8% per annum respectively as of their last reporting date.
It is therefore easy to see why M3 was growing so much more rapidly than M2. The divergent rate of growth of these monetary measures also highlights another point I wrote back in November 2005:
"Why does the Fed no longer want to report the total quantity of dollars in circulation? They know what's coming – massive amounts of dollar creation to fund the worsening trade and federal government budget deficits." [Emphasis in original]
The upshot of all this is that we are without any accurate calculation of M3. Nevertheless, I have developed a work-around that for now will enable me to resurrect the Fear Index. The reliability of this work-around will diminish as we move further away from February 2006, but for now it is adequate.
I have calculated M3 through July 2006 by assuming that it has continued to grow at 8% per annum, which approximates its growth rate in the last two months the data was reported. As a result, I have taken the chart included in Letter No. 375 with my Fear Index forecast and updated it through July 2006, as shown in the above chart.
Note that the blue line (actual results) and gold line (forecast results) are difficult to distinguish for the first seven months of this year. The reason of course is that my forecast has proven very accurate. These two lines are virtually sitting on top of one another. In other words, the actual ascent of the Fear Index has been tracking very closely to what I forecast back in December. But of course, the important question is what happens from here?
Well, no one knows the future, which is always uncertain and unpredictable. Nevertheless, we can use historical guidelines to make a forecast. The actual method I used in December to forecast the Fear Index's path is proprietary, and for now my intent is to keep it that way. But I am pleased to share with everyone the results. And specifically, I am sticking to my December forecast, as stated in Letter No. 375:
"…the Fear Index [at December 31, 2006] is forecast to be 2.1%. We can assume that the US gold reserve remains unchanged at 261.5 million ounces. We therefore have to estimate M3. Let's assume it grows by 8% p.a. over the next thirteen months to equal $10.98 billion as of December 31, 2006. With this data and assumptions, we can now solve for the gold price, which equates to $900 per ounce ($28.94 per goldgram)."
Will this $900 target be hit? Will the Fear Index continue to closely track my forecast?
These answers are of course unknowable. We will have to take it day by day, month by month, and see what happens. But there are two important points, which are the reason I use the Fear Index in the first place.
First, the trend in the Fear Index is rising. Therefore, in this environment, maximize your holding of gold and minimize your holding of dollars and dollar-denominated assets (like T-Bills bank deposits, etc).
Second, even though the Fear Index has climbed a long way, it is still below levels reached at other key low points in the gold market, specifically, in 1971, 1976, 1982, and 1993. This low level means that gold is still way undervalued. It is still a cheap asset, relatively speaking, which leads to the same conclusion as above – maximize the weight of gold you hold and minimize the amount of dollars.
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