Future Fed Policy Will Continue To Fuel The Bull Market In Gold

by: Ben Mountifield

On 13 September 2012, the Federal Reserve announced its third round of Quantitative Easing, or QE3. In making the announcement Chairman Bernanke told us that, if "the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved."

A 5 year chart of Federal Reserve's balance sheet

(Click to enlarge)

Charts courtesy of federalreserve.gov

On 8 August 2007 the Fed's balance sheet it stood at $869 billion. On 21 November this year it stood at $2.853 trillion.

Bernanke also conveyed that the FOMC (Federal Open Market Committee),"currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015".

However, it now seems likely that during 2013 the Fed will replace its calendar date of "mid-2015" with a numeric threshold for the unemployment rate, a subject which has been extensively debated by the committee in the past.

According to the minutes of the 24 October FOMC meeting, "Participants generally favoured the use of economic variables, in place of or in conjunction with a calendar date, in the Committee's forward guidance, but they offered different views on whether quantitative or qualitative thresholds would be most effective. Many participants were of the view that adopting quantitative thresholds could, under the right conditions, help the Committee more clearly communicate its thinking about how the likely timing of an eventual increase in the federal funds rate would shift in response to unanticipated changes in economic conditions and the outlook".

The chief supporter of a threshold for unemployment - that would determine when monetary policy might be tightened - is Federal Reserve Bank of Chicago President Charles Evans. Initially Evans had argued in favor of the Fed refraining from raising rates until unemployment fell below 7%, so long as inflation stayed under 3%. However in a speech on Tuesday he said that his initial proposals were "too conservative".

Evans now believes that "a threshold of 6.5% for the unemployment rate and an inflation safeguard of 2.5% … would be appropriate".

In addition to changing its focus to a target for unemployment, I also expect the Fed to expand its program of quantitative easing when Operation Twist comes to an end at the end of this year.

Under Operation Twist, the Fed is selling bonds with a maturity of less than 3 years and buying bonds with maturities of 6 to 30 years, thereby extending the average maturity of its bond portfolio. When the scheme comes to an end, the Fed is likely to increase its asset purchases from the current $45 billion per month of mortgage-backed securities (MBS), to $85 billion in MBS and Treasuries.

According to the minutes of the 24 October FOMC (Federal Open Market Committee) meeting, "a number of participants indicated that additional asset purchases would likely be appropriate next year after the conclusion of the maturity extension program [Operation Twist] in order to achieve a substantial improvement in the labour market."

During 2013 we also expect to see the Fed and other central banks take further steps to try to encourage bank lending and thus spur money velocity. That's because no amount of money printing will lead to inflation without a pickup in money velocity, and as we have pointed out before, inflation is the only politically palatable "solution" to the western debt crisis.

We would also not be at all surprised to see the Fed and other central banks increase their inflation targets. They may even scrap them altogether in favor of nominal GDP (NGDP) targeting, which would allow them to hold rates low until NGDP returned to its pre-recession trend.

As Financial Times columnist Wolfgang Münchau explains, "You can think of nominal GDP as the sum of real GDP and inflation. If real growth falls, the central bank would thus have to drive up inflation. Conversely, if real growth rises, the central bank would have to bear down on inflation much harder than it would do under the pure inflation targeting regime."

At the end of October, the Treasury Department warned that the U.S. government is likely to reach its $16.4 trillion debt limit by the end of this year. However, two weeks ago Senate Majority Leader Harry Reid said that the Senate stands ready to increase the debt limit by another $2.4 trillion. "If it has to be raised, we'll raise it," he said.

To me it is a given that the legal limit on U.S. federal debt will continue to be raised. In fact, if Treasury Secretary Timothy Geithner had his way, Congress would eliminate the legal limit on the amount of money the government can borrow altogether.

The FOMC holds eight regularly scheduled meetings during the year and the final meeting of 2012 is scheduled to take place on 11 & 12 December.

The bottom line

We expect the Fed to continue to lead the charge with ever more aggressive monetary policy. This will mean that interest rates will remain deeply negative and that the "race to debase" and the currency wars will continue. All of which provides an ideal environment for real money, i.e. gold and silver, and we expect the bull market in both to continue for at least another 3 to 4 years.

Most investors hold gold as a form of wealth or portfolio insurance. Not only does gold protect your wealth from inflation, it also protects the rest of your portfolio from a host of systemic risks. Gold is a highly liquid asset that is universally accepted as a means of payment. It is also unique in that it is the only asset that is not simultaneously someone else's liability.

Because gold is your insurance, we advocate owning physical gold that is outside of the banking/ financial system, rather than by simply buying an ETF (Exchange-Traded Fund) such as GLD. That's because an ETF is a paper derivative of gold designed to reflect its performance, and the holders of ETFs are exposed (often unwittingly) to a host of risks, from movements in the Foreign Exchange markets, to there being multiple claims on the same metal - exactly the sort of risks you are trying to avoid when owning gold.

Those looking to capitalise on the rising price of gold should look at using companies such as BullionVault or GoldMoney, which store your gold for you in physical (and crucially allocated) form, in exchange for a small fee. We also prefer to accumulate gold on a regular basis rather than trying to time the market.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.