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Following comments from the Federal Reserve Chairman Ben Bernanke before the Senate Banking Committee, the price of gold rose significantly. The Fed chairman was on an all out mission yesterday to debunk fears of whether or not the current quantitative easing program underway by the Fed is likely to continue at full speed.

Questions about inflation were answered with appeals to emotions for the unemployed. Bernanke saw the risks to the Fed's actions as mythical and his remarks were biased just enough to confirm that he is trying to persuade markets of the Fed's conviction in its policy.

You Heard it Here First

I've been arguing since the Fed's last two policy minutes releases that the notion of an early Fed exit from their record stimulus was unwarranted. The internal dissent over the Fed's action was louder and more abundant than markets are used to but was all coming from Fed members who hold little influence over the effective policy. The Chairman, Ben Bernanke, Vice-Chair Janet Yellen and NY Fed President Bill Dudley have been increasingly dovish and united so should be persuading markets of the chances of an incline in stimulus rather than a halting.

Senators and Fed Chairman Don't Understand Monetary Policy

The ignorance over monetary policy by the leaders sitting on the banking committee is astounding. As a Fed critic myself, I normally enjoy when a critical member of Congress attacks the Fed but too frequently their attacks are improperly communicated and ripe with errors. Senators Bob Corker and Richard Shelby were perfect examples of committee members who attacked Bernanke without the right tools, but still managed to beget some added errors from Bernanke himself.

We'll leave Shelby's failure to understand what the Fed has purchased aside and instead focus on Corker. During an exchange with Senator Corker, Bernanke was asked about the Fed's independence given their plan to pay interest on reserves as a means of taming inflation and gave two very odd answers.

For those who don't know, basically the Fed plans to control inflation by paying an attractive interest rate to banks, sometimes called IOR, who store their money at the Federal Reserve. By doing so, the Fed 'contains' this money from being lent out and multiplying through credit markets which would pressure up aggregate prices otherwise.

Bernanke's first answer is that the tax payer benefits from interest on reserves. Bernanke explains that on the one hand the Fed has reserves which represent their funding cost and on the other hand they have securities which produce yields. If their securities yield more than their funding cost then the Fed garners a profit which they can remit to the Treasury.

All of this is fine except the first part, where Bernanke insinuates that the paying of reserves is part of the benefit to tax payers. The only conceivable benefit exists after the cost of funding is factored in, so who knows what Bernanke is saying here. The higher the Fed's cost of funding, the less the Fed can remit to the Treasury because its earnings spread diminishes. Moreover it is curious that Bernanke thinks the Fed's cost of funding will be less than its securities. Keep in mind the Fed has accumulated its portfolio during historic lows for interest rates. If the Fed needs to raise the rate it pays on reserves to any substantive amount, the Fed will on net be accumulating losses on an ongoing basis as its interest expense exceeds its earnings. The chairman could retort that reserve balances are lower than their total assets, but this doesn't factor what reserve balances might be during a period where the Fed is trying to attract higher reserve balances.

Corker then went at Bernanke saying that the Fed is threatening its independence by enriching banks with the interest that its paid only for Bernanke to respond that this is a myth. Bernanke said that the banks will get paid market rates, and not receive a subsidy in terms of their interest payments on their reserves. This is another highly questionable response by the Fed chairman and especially when done trying to debunk someone else's supposed myth. The whole purpose of paying interest on reserves is to sway investors from engaging in risky market activities which are not represented by high enough yields following previous Fed stimulus. The Fed accomplishes this by offering risk free interest to banks which, if even at the same level as banks would receive elsewhere, is a subsidy given the risk free nature of the loan. Without an incentive over the market the Fed's interest on reserve policy is impotent.

Bernanke basically made absolutely no sense in either of these responses and someone should seriously question his qualifications based on these answers.

See the full exchange referenced between Senator Bob Corker and Ben Bernanke

The reality of interest on reserves, for those interested in the bigger picture, is that they are temporary measures. It's odd when they are listed as a part of the Fed's exit strategy when in reality all they do is dig the Fed deeper into a bind. The policy simply persuades banks to hold their reserves at the Fed for the time being by allowing banks to walk away with more money than they deposited for doing so. Therefore interest on reserves really are inflationary as banks have no desire to donate money to the Fed and only hold cash at the Fed to defer future spending while earning an attractive interest rate in relation to the risks. How then does the Fed unwind from the build up in reserves which banks will eventually spend? What's the exit strategy from the exit strategy? Seems like Bernanke has lost his totem to differentiate dream and reality.

Dollar Up, Stocks Up, Gold up

U.S. dollar and Japanese Yen rise throughout Bernanke's testimony:
(Click to enlarge)

Curiously the dollar performed well throughout Bernanke's testimony even as gold ascended. This seems to be related to a risk-off sentiment in the currency markets following the ongoing news from yesterday that Italy is presently unable to form a government. The risk-off story seems to have weight as the dollar's strength has been accompanied by strength in the yen as well, the other major funding currency. As swap lines draw down from the Fed, remember the Fed set up credit lines for the European Central Bank to use to supply dollars when they become scarce in Europe, the dollar will resume its decline. This is made more true by the Fed being the most expansionary major central bank, printing $85 billion a month on net, and will impact not only the dollar but all assets, most especially gold.

$2,000 Gold

I have noted this before and continue to target the gold price at $2,000/oz for the end of 2013. The number is not just a pretty whole number but is derived by my conservative estimate of the growth in the Fed's balance sheet and applying a similar growth trajectory to the price of gold. The pretty number only plays a small part. Given that the market seems to expect little movement from the Fed and even a teetering off of Fed stimulus, the continued efforts by the Fed will surprise gold markets on the upside.

In the coming weeks Bernanke and the Fed leadership will likely reiterate their commitment to maintaining policy stimulus and slowly but surely the market will begin to believe them. I even believe there is a chance stimulus measures increase as early as the Fed's next meeting at the end of March. In the least. Bernanke will use his press conference following their next statement to solidify further the case for gold. Each appearance by the Fed chairman seems targeted to this end now, and today's testimony before the House Financial Services Committee should be no different.

Given that gold has much room to go, in my opinion, going long something like the SPDR Gold Trust ETF (GLD) or my preference of put options on Ultrashort Gold (GLL) will yield healthy profits by year's end.

Source: Bernanke Solidifies Gold Path To $2,000/Oz.