The point of this piece is to determine the crux of Fed policy, make a conclusion regarding the efficacy of its approach, and the associated implications for gold.
What is the Point of QE3?
Ultimately, the Fed seeks to depress long-term borrowing rates - specifically mortgage rates - via QE3's monthly purchases of mortgage-backed securities (MBSs). The goal of this measure is to stimulate home purchases, which will in turn give rise to higher home values, which will ideally precipitate rising domestic consumption as Americans "feel" wealthier. With 70% of the U.S. economy comprised of consumer spending, strength in this component of U.S. GDP is integral for achieving higher employment - hence the Fed's approach.
How Consumer Spending can Influence Gold
As it pertains to gold, consumer spending and broader employment in the U.S. are inextricably entwined with Fed policy and the associated monetary dilution. With the Fed committed to indefinite monthly bond purchases until unemployment has reached a more satisfactory level, Fed money printing is directly influenced by consumer spending. So long as consumer spending remains muted, unemployment will remain stubborn, and the printing press will have to keep running - unless of course the U.S. economy can achieve a structural shift to a new, more sustainable engine of growth; as opposed to depending on domestic consumption. For as long as the Fed is printing money, gold and other intrinsically valuable assets will enjoy a healthy degree of support on a wave of new dollars. With this in mind, anyone monitoring the outlook for gold will do well to stay apprised of any developments in the domestic consumption arena.
Recent Revisions to Third Quarter Economic Growth and Consumption
The U.S. Department of Commerce recently provided revised third quarter economic data to include revisions to GDP growth and consumer spending. The statement detailed better-than-expected GDP growth of 2.7% in the third quarter - revised upwards from the initially reported 2%. However, the seemingly positive skew of this revision was muted by lower growth in consumer spending, with the report detailing a 1.4% rise as opposed to the previously indicated rise of 2%. While a higher rate of economic expansion would intuitively benefit investor confidence and elicit a rally in risk assets, we have established the importance of consumer spending and the downward revision in this economic metric served to mitigate any market buoyancy as the result of the better-than-expected third quarter GDP growth.
If we take a closer look at the higher revision of U.S. GDP growth in the third quarter, it becomes clear that a large part of the growth was derived from a rise in inventories. Per the U.S. Department of Commerce report linked above, growth in private inventories added 0.77% to third quarter GDP growth; without this component, GDP growth in this period would have been 1.9%. The Bureau of Economic Analysis (BEA) provides the following information on private inventories:
Change in private inventories (CIPI), or inventory investment, is a measure of the value of the change in the physical volume of the inventories-additions less withdrawals-that businesses maintain to support their production and distribution activities.
Inventories are maintained by business in order to facilitate the production and distribution of goods or services. The items held in inventory may be in the form of goods ready for sale (finished goods), of goods undergoing production (work in process), or of goods acquired for use in the production process (materials and supplies).
Inventory investment is one of the most volatile components of gross domestic product (GDP), giving it an important role in short-run variations in GDP growth. Moreover, inventory movement plays a key role in the timing, duration, and magnitude of business cycles, as unanticipated buildups in inventories may signal future cutbacks in production, and unanticipated shortages in inventories may signal future pickups in production. (emphasis mine)
As indicated in the BEA's explanation of private inventories, "unanticipated buildups in inventories may signal future cutbacks in production..." The third quarter's gain in private inventories could be considered unanticipated in light of the data provided by a U.S. Department of Commerce report citing the fact that private inventories subtracted 0.46% from second quarter GDP growth and similarly subtracted 0.36% from first quarter GDP growth. Private inventory buildup jumped from negative territory to positive 0.77% in fairly short order. Considering the BEA's statements regarding "unanticipated buildups in inventories," this third quarter development may portend depressed production and inventory buildup in the fourth quarter. If this is the case, we probably cannot hope for similar support from private inventories in fourth quarter GDP data.
Weak Consumption and Wage Stagnation Mean Weak Jobs Growth
Getting back to consumer spending - which as discussed earlier will more directly influence Fed policy and as a byproduct, gold price action - the U.S. Department of Commerce reported that real personal consumption expenditures decreased by 0.3% while real disposable income decreased 0.1% in October. Wage deflation, combined with an observable preference for deleveraging, will continue to pressure domestic consumption in the short-to-medium term. The two graphs below highlight deleveraging in the U.S.:
Data Source: FRED, Federal Reserve Economic Data, Federal Reserve Bank of St. Louis: Household Debt to GDP for United States; International Monetary Fund; http://research.stlouisfed.org/fred2/series/HDTGPDUSQ163N accessed December 3, 2012
Data Source: FRED, Federal Reserve Economic Data, Federal Reserve Bank of St. Louis: Household Debt Service Payments as a Percent of Disposable Personal Income ; Board of Governors of the Federal Reserve System; http://research.stlouisfed.org/fred2/series/TDSP; accessed December 3, 2012
The two graphs above highlight an established trend of deleveraging as evidenced by decreasing household debt in relation to U.S. GDP as well as lower household debt servicing payments as a percentage of disposable income. With the observable preference of American consumers to pay down debts, wage deflation will only compound this reality. Domestic consumption will continue to suffer as the result of negative or stagnant wage growth.
The graph below details employee compensation in the U.S.
Data Source: FRED, Federal Reserve Economic Data, Federal Reserve Bank of St. Louis: Compensation of Employees, Received: Wage and Salary Disbursements - Consumer Price Index for all Urban Consumers and Compensation of Employees, Received: Wage and Salary Disbursements ; US Department of Commerce: Bureau of Economic Analysis and US Department of Labor: Bureau of Labor Statistics; http://research.stlouisfed.org/fred2/graph/?s[id]=A576RC1; accessed December 3, 2012
The red line represents the percent change in the compensation of employees while the blue line represents the percent change in the real compensation of employees (i.e. real because it takes into account inflation via the consumer price index). As can be seen in the graph, the percent change in compensation of employees - both nominal and real - is currently negative.
The following graph similarly highlights the stagnant skew of real personal consumption and real personal income over the last few months:
Data Source: U.S. Department of Commerce, Bureau of Economic Analysis: Real Disposable Personal Income and Real Consumer Spending; U.S. Bureau of Economic Analysis; http://www.bea.gov/newsreleases/national/pi/pi_glance.htm; accessed December 3, 2012
The Policy Implications of Weak Consumption and Wage Stagnation
Until Americans can enjoy a more substantive rise in personal incomes, it seems safe to assume that consumption will remain subdued. If we can accept that the consumption outlook is fairly bleak, yet still represents 70% of the U.S. economy, we can similarly assume that unemployment will not decrease materially in the short-to-medium term. Following this logic, since the Fed's monthly bond purchases under QE3 are directly tied to the rate of unemployment, the total size and longevity of this program will be determined by the ebb and flow of domestic consumption. As the Fed's accommodative measures could easily prove ineffectual in the face of income stagnation, or even deflation, we can expect the Fed to either maintain its current measures for an extended period of time or adopt a new course of action. As the Fed has all but exhausted its policy arsenal, a gambling man would probably put his money on the Fed's continuation and expansion of current measures. This will result the ever-rising creation of new dollars which is positive for gold.
How Record Low Interest Rates Can Influence Consumption
Another component of the consumer profile in the U.S. that is important to take note of within the framework of the future consumption outlook is interest rates. The interest income realized by American consumers directly influences their perceived wealth and as a result can play an important role in dictating their consumption patterns. With the huge Baby Boomer demographic in the U.S. reaching or having reached retirement, interest income plays an even more important role in their consumer profile. As this demographic often relies heavily on interest income to sustain their lifestyle, they are especially susceptible to the tribulations of the current low-rate environment. Individuals realizing little-to-no interest income from their nest egg will be increasingly disinclined to spend money. With a huge swathe of Americans tightening belts amidst their "golden years," the depressive effect on overall consumption should not be ignored.
The graph below addresses the interest income picture in the U.S.
Data Source: FRED, Federal Reserve Economic Data, Federal Reserve Bank of St. Louis: Personal Income Receipts on Assets: Personal Interest Income; US Department of Commerce: Bureau of Economic Analysis; http://research.stlouisfed.org/fred2/graph/?s[id]=PII; accessed December 3, 2012
As can be seen in the graph above, besides the unsustainable returns realized as a result of rising home prices between 2004 and 2008, the percent change in personal interest income over the last 12 years has been consistently negative. Moreover, the data reflected in the graph details nominal personal interest income and does not take into account inflation. While inflation has remained muted over this timeframe, real personal interest income would be lower still after accounting for inflation. Negative real interest rates - when interest received fails to keep up with the inflation rate - results in lost purchasing power over time. With the Fed saying "exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015," negative real interest rates are an unfortunate reality that investors and retirees will have to deal with going forward.
The current dynamic of weak consumption is in stark contrast to the economic maxim that a low-rate environment should encourage spending. Despite the fact that the Fed has effectively removed one of the main incentives for saving (i.e. interest income), the consumer profile in the U.S. has not adopted the paradigm shift policymakers would like. This reality evidences the innumerable variables at play in an economy that prevent or at least inhibit policymakers' ability to artificially generate their desired results. The market's natural progression can be delayed, and perhaps even temporarily redirected via policy manipulation, but the structural considerations in the U.S. economy will continue to impede material growth in consumption as Americans react to dynamics at play that the Fed cannot change.
Assuming Americans continue deleveraging and wages continue to stagnate, domestic consumption will probably remain weak in the short-to-medium term despite the Fed's best efforts. If this is the case, as it certainly appears to be, an economy oriented towards domestic consumption will remain in the doldrums as unemployment similarly remains unchanged. As a result, the Fed will be forced to either review and adjust its policy approach - or keep bolstering the same ineffectual measures in an attempt to forcibly manifest the desired outcome (i.e. lower unemployment). Perhaps over time the Fed's policies will achieve their goals, but in the short-to-medium term it seems unlikely this preferred reality will come to fruition. Given the fairly bleak outlook for domestic consumption, we can expect static Fed policy for some time to come.
The combination of record low interest rates - and negative real interest rates when accounting for inflation - combined with an ongoing and ever-expanding production of new dollars means that Fed policy will remain a major bullish fundamental underpinning the values of gold and other inherently valuable assets. Many investors have refrained from taking positions in gold as a result of the "missed the boat mentality," but the fact remains that the policy bias maintained by the Fed, which has in large part driven gold prices to their current levels, will continue unabated for the foreseeable future.
Considering the arguments made above, gold and similar assets remain attractive despite nominal valuations being perceived as high. As we can reasonably expect a continuation of accommodative Fed policies, gold, silver, and other finitely available assets will be an attractive means of capitalizing on these expectations. For those individuals anxious to short Treasuries and similar safe haven bonds - as we reach the tail-end of the bond bull market - we may have to wait a little longer as the Fed's policies artificially prop up these bonds' valuations amidst the broader low-rate environment. The safe haven bond complex will probably be able to eek out further, but nominal, gains as market uncertainty, geopolitical risk, and the accommodative policy stances of the world's central banks are not going anywhere soon.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.