The investment world seems willing to accept an increase in interest rates by the Federal Reserve when the Board meets later this month. In large part the reason for this attitude is that the Federal Reserve is expected to take a moderate approach to the process of raising rates. Translating these thoughts and Federal Reserve policy announcements is rather easy. The Federal Reserve is going to do little to change the rate of increase in the U.S. money supply.

Monetary economics is really a rather simple subject. If the central bank, the Federal Reserve, allows the money supply to increase faster than the production of goods and service increases, prices will rise. If a country has more money than goods, the prices of those goods will go up. The same is true for the price of Gold in that country's currency.

In short, if the Federal Reserve allows the supply of U.S. dollars to increase faster than the total quantity of Gold increases, the dollar price of Gold will rise. That is what they have been doing, and Gold has been responding. The Gold Bubble is still on track to carry Gold to over US$1,200. What the Fed does is more important than what they say. Open mouth policy is not action.

Before looking directly at the relationship of Gold and the U.S. money supply, let us review the performance of the U.S. money supply. In the next chart is graphed the narrowest measure of the U.S. money supply, M-1. This measure is essentially composed of bank checking deposits and currency in circulation.

The historical pattern of the U.S. money supply is probably somewhat different than many would have expected. In the middle of the 1990's the U.S. money supply peaked, and then fell. The money supply did not recover till the new century arrived. Many forcess contributed to this pattern. In part the collapse of the Japanese banks was a factor in this development.

The consequences of fewer dollars existing meant that the value of dollars went up and inflation fell.

In the late 1990s the U.S. money supply bottomed. As is apparent from the graph, the money supply has been growing since then. In the past couple of years the rate of growth in the U.S. money supply has been accelerating. This acceleration is evident by the higher slope of the line. You can observe this by following the line by laying a pencil across it. As the point of the pencil starts pointing higher, the slope is greater and the growth rate has increased.

Now that we have reviewed the history of the U.S. money supply, let us compare the price of Gold to that data. In the next graph the monthly price of Gold is graphed versus the U.S. money supply. Yes, the graph is a little hard to read in detail for a large number of data points are used. The message to grasp is how close the dollar price of Gold and the quantity of U.S. dollars have been tracking together in recent years.

In the early period shown in the graph, Gold and the U.S. money supply do not seem to track well. Part of the reason for that appearance is that the U.S. money supply was going down, and Gold should have been going down. Second, this period coincides with the era of heavy central bank lending before the Washington Agreement on Gold. The Gold market was not able to act naturally.

In recent years the tracking is excellent. From January 1998 to the present, the R² was 77%. What does that mean? R² tells us how much of the variance of the U.S. dollar price of Gold can be explained by the variance of the U.S. money supply. What does that mean? Well, it tells us how much of the wiggles in Gold's price are caused by wiggles in the money supply.

Important also is that the relationship has strengthened. From January 1999 to the present, the R² was 85%. A significant portion of the action in the U.S. dollar price of Gold is being explained by the size of the U.S. money supply. That relationship is as it should be.

In the next graph we have taken the recent history shown in the previous graph and added projections of M-1 at two different growth rates. M-1 is projected forward at 4% and 8%. We can then use these projections to approximate where the price of Gold might be in future years. We can do this because of the strong fit previously demonstrated.

The implication of this picture is that outlook for Gold's dollar price remains extremely favorable. Gold is easily going to exceed US$500 in a the near future. Such a projection does not factor in a collapse of the U.S. Housing Bubble and the subsequent devaluation of the U.S. dollar.

Fundamentals remain extremely well positioned to push Gold's U.S. dollar price higher in the years to come. However, that does not prevent Gold's dollar price from doing a lot of things in the short-term. A serious drop though would have to be ruled out. Short-term pessimism, especially when created by the money handlers of today, creates opportunity for long-term investors.

As an aid in justifying the growth rates used in this graph we have included one more graph on the growth rate of M-1. As you can see, the Federal Reserve has adopted policies creating some of the highest growth rates experienced in about a decade. Second, policy has been a little erratic. As the monetarists say, monetary instability leads to economic instability.

Recently Chairman Greenspan has suggested that the Federal Reserve's actions would be "measured" but prepared to act against any signs of inflation. Only when the economy seems to be expanding does it tend to have this view. One gets the impression that the Fed is ready to change its stripes to spots on a moment's notice. We doubt that.

The Federal Reserve ignored the price action during the Stock Market Bubble and has ignored the dangerous repercussions of the current Housing Bubble. Clearly the signs are pointing toward a higher level of price inflation as measured by the Fed's favorite index of the day. Will the Federal Reserve put the Housing Bubble at risk, or simply find another favorite measure on which to focus?

Should the Federal Reserve actually act like a real central bank by pushing interest rates higher, the Housing Bubble will collapse. With plummeting housings prices and mortgage default rates skyrocketing, what will be the Fed's response? What will be the response of foreign exchange markets when the U.S. plunges into a near bottomless recession under collapsing housing prices?

The bull market for Gold and Silver remains intact. Ten years were required to put these fundamentals in place. Such forces do not disappear suddenly. The Housing Bubble is not going to sneak off into the night unnoticed. The current account deficit is not suddenly going to be resolved by the Good Fairy putting quarters under everyone's pillows. Federal Reserve officials are not suddenly getting "religion."

In the past year excessive optimism built up in both Gold and Silver. That they are correcting within a greater bull market is not something to fear. Wisdom says buy low and sell high. Investors should be looking for buy points on both Gold and Silver. While the funds and other trading entities are departing, they are leaving some attractive prices for investors. Remember the long-term target of over $1,200, not the price today created by the selling of some portfolio manager at a hedge funds. The same geniuses were buying technology stocks as the NASDAQ approached 5000.