Over the past year, short-term changes in the price of gold, both up and down, have largely mirrored shifting expectations of U.S. Federal Reserve monetary policy and the reaction of short-term institutional speculators operating in futures, ETF, and other “paper” derivative markets. The past week - with gold first falling sharply then recovering smartly, and then dropping again - has been no exception.
To little surprise, gold registered its biggest one-day gain of the year on Tuesday as Federal Reserve Board Chairman Ben Bernanke, in his semi-annual report to Congress, eased market fears of an early reversal in the central bank’s super-stimulative monetary policy.
Gold-price weakness in the past couple of weeks prior to Tuesday’s swift price rise has owed much to confusion and ambiguity about prospective Federal Reserve monetary policy - confusion prompted by the Fed’s own minutes of its January policy-setting meeting and public pronouncements by some Fed officials advocating an early reversal in the Fed’s exceptionally accommodative policies.
During Tuesday’s report to Congress, Bernanke unambiguously reiterated the central bank’s commitment to maintain its program of quantitative easing (otherwise known as printing money) thereby triggering a swift gold-price advance.
But what the Lord giveth the Lord taketh away: On Wednesday, his second day of Congressional testimony, the Fed Chairman seemed to backtrack (at least to many of the traders calling the tune for gold these days), saying the Fed might review its exit-strategy from easy-money policies some time soon. And, predictably, the gold price swiftly tumbled.
What’s the truth about prospective Federal Reserve monetary policies? After all, this is a crucial determinant of the future price of gold. Surely, Wednesday’s promise to review its exit-strategy is not a signal that the Fed has any intention of altering its easy money course any time soon. For this reason, I think the latest sell-off will be short lived as traders and other gold-market participants reassess monetary policy prospects for the year ahead.
I’m of the view that the U.S. economy is somewhat weaker than portrayed by recent official statistics and news accounts of the economy’s performance. Moreover, fiscal drag this year - and public uncertainty over prospective tax and spending policies - could steal as much as 2.5% from U.S. gross domestic product and push the economy into renewed recession sometime this year.
Washington’s inability to come together with a pro-growth fiscal-policy mix puts much pressure on Bernanke’s Fed to maintain - and possibly even step up - its on-going program of quantitative easing and extremely low interest rates.
Automatic across-the-board Federal spending cuts (sequestration), or even more sensibly managed spending cuts with or without some form of tax increase, or simply kicking the can down the road - whatever the outcome, fiscal drag is likely to further retard economic activity, raising the likelihood of continued - or even increased - Federal Reserve monetary accommodation in the months ahead.
What are the sources of fiscal drag?
- First, households are continuing to adjust to this New Year’s payroll tax hike by spending less;
- Second, some Federal spending cuts, either sequestered (automatic) or negotiated by Congress and the Administration, will likely take place in the weeks and months ahead;
- Third, an increase in Federal taxes, possibly by closing some of the loopholes now enjoyed by business and high-income households, will likely be agreed to sooner or later.
- And, fourth, more spending cuts and tax increases at the state and local level across the country,
In the current political and economic environment - with many households still suffering and deeply in debt, and with the unemployment rate still unacceptably high and the numbers of long-term unemployed or under-employed growing, and with fiscal drag likely to make things worse - the Fed remains the only effective policymaker able to mitigate the economic suffering.
It’s principal policy tools are monetary accommodation - otherwise know as quantitative easing through the on-going purchase of U.S. Treasury and Agency debt to the tune of $85 billion per month - and maintenance of near-zero interest rates with the hope of stimulating bank lending, consumer spending, home purchases, and business investment.
Of course, these are also inflation-producing policies - and very much pro-gold. They always have been - and likely always will.
For all its talk to the contrary, the Fed must be well-aware of the ultimately inflationary consequences of quantitative easing. Indeed, Bernanke’s Fed must be tacitly counting on higher inflation to erode the real burden of debt (measured by the ratio of debt to gross domestic product) in order to restore household balance sheets sufficient to encourage a meaningful recover in personal consumption, without which the economy will continue to under-perform and unemployment will remain painfully high.
