Forget QE2: The Only Commodity to Own Is Gold

by: Doug Eberhardt

What is Bernanke really doing when it comes to all his rhetoric about stimulating the economy more? Like a good magician, he is waving one hand (QE2) while the other hand fights deflation. The waving QE2 hand is just an illusion.

In the past couple weeks I have been trying to impress upon readers that Bernanke has been repeatedly trying to threaten quantitative easing round two (QE2) and in doing so, has managed to accomplish what he has set out to do without actually having to do any actual easing come November 3rd when the Fed Board meets again.

From Why Should Anyone Believe Bernanke When He Says “We’re Not Out of Ammo?”

What they do with these types of statements is try to convince people the Fed is in control. But it is just the words they think that will move markets, not actual policy. In other words, they think that just by mentioning something, it is gospel….and so the people and markets will react accordingly, accomplishing their goals.

From Bernanke Has Everyone Fooled With “Talk” of More Fed Quantitative Easing.

The interesting thing to me is people still believe Bernanke at his word. But what would be the consequence of even more quantitative easing? It would be disastrous to the economy and the U.S. dollar. So why not accomplish what he wants to occur without doing anything?

The Fed’s hand doesn’t have to be exposed yet. Treasuries are still where money is flowing. If everyone was worried about the U.S. dollar falling off the face of the earth, would the 10 year Treasury be at record lows, currently hovering around 2.4%? Would the ProShares UltraShort 20+ Year Treasury (NYSEARCA:TBT) be at multi year lows?

Bernanke Is Afraid of Deflation

What I believe Bernanke is most afraid of is deflation. Deflation occurs naturally when an economy reverses the excesses of the credit expansion. As businesses and consumers cut back, loans are repaid or defaulted upon, and only the good survive. As the economy contracts, businesses that are trying to survive are forced to cut back with layoffs and cutting of prices to try and stimulate demand. This conflicts with the Federal Reserves mission.

The Federal Reserve's mission is:

  • conducting the nation's monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates
  • supervising and regulating banking institutions to ensure the safety and soundness of the nation's banking and financial system and to protect the credit rights of consumers
  • maintaining the stability of the financial system and containing systemic risk that may arise in financial markets

Unemployment is rising, not decreasing, as more and more fall off the books of being counted. This issue deserves its own analysis, but I want to concentrate on Bernanke's attempts to control prices.

Deflation and Prices: Why Does the Fed Not Want Lower Prices?

The results of a deflationary credit contraction is that prices decline. So why would the Fed want stable prices? Declining prices are a good thing for the consumer. Professor of Economics at the University of Angers in France, Jörg Guido Hülsmann, in his book Deflation & Liberty, sums it up as follows;

There is absolutely no reason to be concerned about the economic effects of deflation—unless one equates the welfare of the nation with the welfare of its false elites.

Is it the "false elites" the Fed is concerned about? Perhaps the owners of banks? We've already seen what the Fed can do when their favored sons are in trouble with the 2008, 2009 economic crisis.

Deflation and Lower Prices

Walmart (NYSE:WMT) has been successful with their low price business model. While the influence of Walmart has been negative to the small Mom and Pop suppliers in small towns across America, putting most out of business, it has been good for the consumer as it has allowed them to buy goods at lower prices.

So what Bernanke and the Fed are doing is essentially talking up prices by threatening to bring about more quantitative easing (QE2). This reverses the trend of lower prices, and for awhile, as can be seen of late, it has worked.

Prices Were Falling Earlier In the Year

Prices had been falling. As of July, 2010, producer prices actually fell for the third time in four months. Consumer prices fell for the third straight month. Lumber declined 21% in five weeks. Copper prices had fallen. The Journal of Commerce (JOC) Commodity Index that tracks the growth rate of steel, cattle hides, tallow and burlap plunged 57% in May, the most since October 2008. Real estate prices were continuing to decline now that the government faucet has been turned off. Sales of new homes dropped a record 32.7% in May to the lowest level in at least four decades.

What happens when prices keep falling? Businesses aren’t making as much money and tax receipts subsequently fall as consumers cut back. The effect of this is less money for government to run things. The Fed enters and pumps in more money to stimulate GDP. This is to make up for the other factors of GDP that were declining, consumer spending, business spending and exports. The hope is that businesses will start expanding, consumers will spend and GDP will grow.

Quantitative Easing Round 1

To keep things status quo or even improve, the government feels the necessity to step in and make up for the decline in GDP, by artificially stimulating the economy rather than letting the economy adjust on its own.

Richard Koo, in his book Balance Sheet Recession, describes why Bernanke has implemented quantitative easing (QE1), even though he wrote this in 2003;

The problem is that a balance sheet recession is no ordinary recession. In this recession, which is brought about by the fallacy of composition, the

economy is weakening because most companies are looking backward as they try to repair their balance sheets. But because the companies are minimizing debt instead of maximizing profits, demand is lost all around the economy. If no one came in to fill the shortfall in demand created by everyone paying down debt, the whole economy could fall into a vicious cycle.

And that's what Bernanke and company have been worried most about.

The Results of Bernanke's First Attempt of Quantitative Easing

The results of Bernanke's round one of stimulus were the "green shoots," a term used quite frequently on CNBC during the first round of easing. But the green shoots withered and died. The stimulus didn't work. You don't hear CNBC talk about green shoots any longer.

Granted the stock market has rebounded and the Dow is presently over 11,000, but the stock market does not represent the economy. Does a higher P/E ratio represent true value and a clear picture of the economy? How about when a part of that economy is falsely generated by government intervention/stimulus? Does this represent reality? Simply put, the Dow could shoot to 12,000 from here, but the underlying economy is hanging on by a thread.

A Deflationary Credit Contraction Takes Hold

The first round of quantitative easing hasn't worked in stimulating the economy, as shown by the above data. The deflationary credit contraction was dwarfing the trillions of government stimulus. Banks were not lending. Consumers were not spending or borrowing and businesses cut back and tried to pay off debt or defaulted on it.

Bernanke, already having eased to the tune of trillions, took advantage of a bounce in the dollar that had been occurring, and decided to "talk" of more easing to come; QE2.

Bernanke and the Talk of QE2

On August 27, 2010, Bernanke first started talking of deflation as he mentioned it six times in a speech he gave at the Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, Wyoming.

First, the FOMC will strongly resist deviations from price stability in the downward direction. Falling into deflation is not a significant risk for the United States at this time, but that is true in part because the public understands that the Federal Reserve will be vigilant and proactive in addressing significant further disinflation. It is worthwhile to note that, if deflation risks were to increase, the benefit-cost tradeoffs of some of our policy tools could become significantly more favorable.

Second, regardless of the risks of deflation, the FOMC will do all that it can to ensure continuation of the economic recovery. Consistent with our mandate, the Federal Reserve is committed to promoting growth in employment and reducing resource slack more generally. Because a further significant weakening in the economic outlook would likely be associated with further disinflation, in the current environment there is little or no potential conflict between the goals of supporting growth and employment and of maintaining price stability.

Most of the push up in the price of commodities of late has occurred since that speech and fueled further by Bernanke and other Fed members continual threat of more quantitative easing. Outside of gold, I don't believe the strength in commodities is warranted (gold, while classified as a commodity, I view as money, so is a separate, worldwide demand issue).

Commodities Ready to Resume Decline?

The first chart below shows the run up in commodity prices of late while the second chart shows that the bounce is unwarranted as the demand, represented by the Baltic Dry Index, doesn't confirm the rise in commodity prices by showing any real economic activity occurring like it did during the credit expansion era.

I believe this recent run up in commodity prices to be a bounce in an overall downward trend from the 2008 top and I think they will resume a trend lower shortly once people realize the Fed isn't going to risk bringing down the whole economy through QE2. If there was real inflation, the result of which is higher prices, bonds wouldn't be as strong as they are right? How come Treasuries have been so strong with commodity prices moving higher?

click to enlarge images

What the second chart reveals is that unlike the inflationary credit expansion era that showed economic activity moving up with the prices of commodities, there is no economic activity driving up prices this time around. One would think that rising commodity prices would increase the demand and thus economic activity, causing an increase in shipping costs. This clearly is not happening.

While Peter Schiff and others talk of oil going to over $100 again, I believe his reasoning, from a weaker dollar perspective, is off in its timing. Treasuries, confirm this thinking. Treasuries have been getting stronger despite the dollar, priced in other currencies that are rising, getting weaker. The reason is, people are shedding riskier assets and moving towards the safety provided by Treasuries, gold and silver.

As businesses cut back, as consumers cut back, as governments cut back, prices will fall. There will be less need for oil and thus the price of oil will fall, barring any war rhetoric. These falling prices are healthy for a recovering economy. It is the Fed who tries to manipulate prices in its attempts to "stabilize" that gets in the way of this recovery.

Naturally, long term, the U.S. dollar and all other currencies will continue to decline priced in gold. But remember, prices of homes in the U.S., Japan and almost everywhere else in the world are declining. This is occurring despite all currencies losing over 160% to gold the last 10 years. The fact of the matter is gold will eventually separate itself from other commodities during this deflationary credit contraction. It has already started to, as the purchasing power of gold increases during deflation.

Come November 3rd, don't expect anything but more rhetoric coming from Bernanke and the Fed. Why should they have to actually do anything if they can "talk" the markets where they want them to go?

Right now we're seeing a bounce in the Dollar Index and a fall in the price of gold. Long term, holders of physical gold care not that it falls 20% on its way to 100% and higher gains. Dollar cost averaging into a position makes sense. In this case, you actually hope the price of gold goes lower so you can get a better overall average price. When the Fed actually does move from "talk" to actual QE2, QE3 and QE infinity, which they will, along with more bailouts of anything and everything, you'll be glad you have a position in gold.

Disclosure: Author is long physical gold and silver