Leading Economic Indicators

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Leading Economic Indicators: The #1 Indicator the Fed Fears the Most

by Mark Skousen, Chairman, Investment U
Monday, May 1, 2006: Issue #531

Last month, a reporter for The Wall Street Journal identified five indicators that the Journal thinks the Fed watches to determine the future of the economy and how far it will raise interest rates.

The five leading economic indicators are:

1. Orders for capital goods
2. Initial jobless claims
3. Homebuilder sentiment
4. Retail sales
5. The bond market

In reality, The Wall Street Journal, like most establishment sources, is dead wrong.

While significant, these are not the most important economic indicators forecasting the Fed Funds Target Rate. (And, as I have pointed out in previous Investment U columns, retail sales are downright misleading as a leading indicator.)

For some reason the Journal ignored two indicators that are far more relevant to Fed rate policy.

Don’t Ignore the CPI as an Economic Indicator

One is the Consumer Price Index (CPI), a general indication of current inflationary pressure. Lately, the CPI has been rising, and is now double what it was a year ago.

As long as price inflation continues to rise sharply, the Fed will be forced to raise rates, to avoid negative real interest rates, which is inflationary. Equally, the yield on the long bond will have to rise above 5%.

The #1 Leading Indicator of Inflation and Rising Rates

But The Wall Street Journal has ignored the #1 indicator of future price inflation, dollar weakness, and interest rates and that is the price of gold.

Several years ago, Professor John List (now at the University of Chicago) and I did an econometric model trying to determine which leading indicator best predicted future inflation: Was it the price of oil, long bond, the CPI, or gold?

Surprisingly, oil was the least effective predictor of overall inflation, largely because technology has made our economy more productive on less energy sources. Next came the CPI and the long bond. But by a significant measure, gold turned out to be the best monitor of inflationary pressure. What is driving this inflation?

War and uncertainty in the Middle East
U.S. reinflation
Industrial demand in China and Asia, and, of course
The recent weakness in the U.S. dollar in foreign exchange markets

The dollar fell dramatically last week, after Fed Chairman Ben Bernanke said the Fed Open Market Committee could pause even if inflation risks remain. This may be only the beginning of a serious decline in the dollar. Watch out below!

Gold as an Economic Indicator and the Forecast on this Precious Metal

Fact: Unlike industrial commodities like copper, silver and oil, the yellow metal is never consumed and the vast majority of demand for gold is monetary. This year, total industrial and jewelry demand for gold is 81.3 million ounces, according to CPM Group, a New York-based metals research firm. But speculators now for the first time hold 1.1 billion ounces of gold, more than the amount held by government central banks. [Source: Barron's, May 1, 2006, p. M20].

Contrary to what traders and Wall Street tell you, gold is not just another commodity. It was, and in some ways still is, money. Central banks still hold gold as a last resort asset. It is also an asset that is not at the same time somebody else’s liability.

What is the price of gold telling us? If its current price is sustainable at the $650 level, it clearly indicates the stubborn return of price inflation, and maybe even a sharp fall in the U.S. dollar against foreign currencies. And the price of the Midas metal has been on a tear recently (see the chart below for reference).

The price of gold as a leading economic indicator: 1975 - present.

As the chart above indicates, gold is still below its 1980 high of $850 an ounce. I doubt if it will reach that level again any time soon, but it is clearly gaining momentum right now. Some gold bugs are predicting $2,000 gold, but that won’t happen unless all hell breaks lose, the dollar crashes, or another major terrorist attack hits the West.

I’m surprised that Bernanke has allowed the price of gold to get out of hand. The Fed might soon intervene to calm things down. I don’t think Bernanke wants to start his reign with a crisis like Greenspan did (1987 crash). But it could happen, especially if the dollar starts falling like a rock. He might put the brakes on the money supply (M2), which is currently growing at a 7% rate; raise the Fed Funds Rate above 5%; or announce a concerted sale of gold by the Fed and European central bankers.

Recommendation: Keep Gold In Your Portfolio

Keep gold in your portfolio. I’ve recommended gold and silver stocks in the past. This time, I urge you to add real gold to your portfolio – coins, bullion, rare coins, etc. Here are my favorite coin dealers: Van Simmons, David Hall’s Rare Coins (800.759.7575), or Burt Blumert, Camino Coins (800.348.8001). Or, you can buy an ETF that holds gold bullion: GLD.

If you want to limit your downside risk (though you also limit your upside profit potential), buy an EverBank Gold CD, which is FDIC insured (however, EverBank’s* five-year MarketSafe Gold Bullion CD must be funded by May 16).

Good investing, AEIOU,

Mark

Today’s Investment U Crib Sheet

Precious metals expert Michael Checkan tracks the barbarous relic, and gave his predictions for this year in Investment U # 510, 2006 Gold Outlook: The Seven Factors Polishing this Precious Metal. And as I mentioned above, retail sales are not good leading economic indicators. Read Investment U # 494, Gold as an Inflation and Market Indicator: Where to Put Your Money When Prices Edge Higher.
Contact EverBank at 800.926.4922 or log onto Everbank’s website, and be sure to tell them you’re an Investment U reader. Editor’s Note: While I would recommend the company anyway, my publisher has a business relationship with EverBank and receives compensation if you open an account there.