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Easy Fed, strong gold

Gold continues its upward trend against the dollar, and it is making new highs almost daily against the euro. The Fed yesterday reiterated that it is still terrified (I'm exaggerating to make a point) that the economy remains weak and unemployment remains high, so it plans to keep interest rates very low for a long time. The prospect of an "extended period" of zero yields on cash and cash equivalents is driving investors to anything that shows signs of life these days, and gold now has a 9-year rising trend in place. Gold's current uptrend started almost the same day that the Fed belatedly recognized that the economy was weakening in the wake of the dot-com crash, and as a result of extremely tight monetary policy from 1997 through 2000. Since 2001, the Fed has been much more concerned about the strength of the economy than about the outlook for inflation. That is one big reason why gold is doing so well.

Obama's choice of three new Fed governors does little to reassure investors that the Fed will ever pay more attention to the value of the dollar than it does to the health of the economy. Indeed, all three picks promise to be firmly in the "dovish" camp when it comes to the hardest choice any central banker has to face: whether to tighten to defend the value of its currency, or to ease to support the economy.

While this is an ugly picture, it is also the case that measured inflation has been relatively tame for many years. The CPI has risen at a compound rate of 2.45% over the past 10 years; 2.0% over the past three years; and 2.4% over the past year. The early warning signals of future inflation, however, are not so good. Gold is a prime example, as are commodity prices, a record-steep yield curve, and a dollar that is only marginally above its all-time lows in terms of purchasing power relative to other currencies.

On balance, and given the reinforced makeup of the Federal Reserve, I think investors need to be concerned about higher, rather than lower, inflation in the years to come.

And the fact that gold is making new highs against the euro and almost all other currencies, means simply that our Fed is not the only central bank that is deciding to err on the side of ease. This is a global phenomenon. The forces of inflation are very likely to win out over the forces of deflation.

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