Third Time May Not Bring Charm For The Fed

Includes: IAU
by: Benjamin Shepherd

After spending the first half of the year in a consolidation pattern, gold made a decisive break to the upside in June as the Bank of Japan began a program of quantitative easing (QE) and expectations grew that the US Federal Reserve would follow suit.

And follow suit it did, with the announcement that it would begin buying mortgage-backed securities to the tune of $40 billion a month until the labor market began to improve under its QE3 program.

In years past, such a broad and open-ended program of QE would have been sure to trigger a bout of rapid inflation. As the Fed's QE1 program ran its course between late 2008 and early 2010, commodity prices surged and the valuations of emerging market equities shot higher, as all that easy money moved into the most lucrative market niches. A similar surged occurred as QE2 ran into early 2011.

However, while inflation caused by QE was readily apparent at the gas pump or in the grocery store, the US Consumer Price Index (NYSEARCA:CPI) barely budged. That allowed the Fed to trumpet the success of its easy monetary policy by pointing to improvement in the employment situation and a surge in US equity valuations, while also claiming that its baseline inflation reading hadn't registered a blip. These trends provided the political cover to allow for QE2 and, ultimately, QE3.

Unfortunately, the Fed might not be as lucky this time around.

Housing costs are generally the largest expense borne by an American household and, as a result, they figure heavily into the CPI calculation. Rents actually account for about a third of the index value, so even as fuel and food costs took off like a shot, the index barely moved. Moreover, rents flat lined as the US housing market tanked.

The CPI reading the Fed monitors also excludes food and energy prices, which helped mask the impact of the Fed's actions. In addition, the CPI reading has held below 2 percent for the better part of four years.

Recent housing data points to a stabilization in US real estate prices. In July, the most recent month for which data is available, the S&P/Case-Shiller Home Price Index rose 1.6 percent compared to June and it was up 1.2 percent on a year-over-year basis. A number of particularly hard hit areas such as Tampa, FL-where prices bounced 3.6 percent month-over-month and 5.3 percent year-over-year-registered stronger upward moves than the national average.

Another indicator of improving housing prices is the Federal Housing Finance Agency (FHFA) index of home prices which this week showed its largest year-over-year increase in more than six years. According to the FHFA index, home prices rose by 0.7 percent in August month-over-month and shot up by 4.7 percent year-over-year. The last time the index made a jump anywhere near that big was in August 2006, for a 4.9 percent gain.

While a couple of data points don't quite constitute a trend, they do show that the Fed might not be able to take refuge in weak housing prices this time around.

As energy prices creep higher they'll begin to show up in the CPI reading. Energy touches every step of the manufacturing process. Raw materials must be transported to factories, which in turn require energy to operate. Energy is expended transporting finished goods to market and retailers need to light, heat and air condition their stores.

While energy costs might be specifically excluded from the Fed's preferred version of the CPI, as they creep higher they inevitably bleed through.

Gold investors are well aware of these facts, which is why gold has finally begun to move higher despite flat CPI readings (see chart, below). Investors are protecting their portfolios against the insidious impact of inflation.

Source: Bloomberg

To be clear, I'm not expecting an outbreak of hyperinflation. With lackluster growth in the US, slowing growth in China and the continued threat of recession in the euro zone, there isn't enough upward pressure on prices for inflation to get out of control in the foreseeable future. Considerably stronger global growth is a prerequisite for that to occur.

Nonetheless, central banks around the world are walking a very fine line between inflation and deflation. If growth were to take off at a better clip than expected, inflation could very easily tick above their comfort zones. In the meantime, enough folks are concerned about the prospect of a sharp rise in prices that we should see a decent run higher in gold prices.

Physical gold is always the best hedge against the prospect of inflation and, as a result, the US gold spot price is what I track. But I understand that due to storage costs and other concerns many individual investors aren't in a position to hold physical bullion.

I recommend a position in iShares Gold Trust (NYSE: IAU). Each share of IAU is backed by 1/100th of an ounce of physical gold maintained in the fund custodian's vaults. Those holdings are periodically audited and the results of those inspections are posted on the fund's website, allowing you to make sure that the gold is, in fact, there.

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.