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Falling Oil Prices Signal QE3 Is Too Timid

|About:SPDR Gold Trust ETF (GLD) Includes:Barrick Gold Corporation (ABX), AEM, AUY, GG, NEM, USO

West Texas Intermediate spot crude prices closed at $98.30 on September 13, the day the Federal Reserve announced QE3. On September 24 the spot price closed at $91.93, a decline of over 6%. One reason for the price decline could be the old saw buy the rumor and sell the news as crude oil prices rallied into the Federal Reserve's decision in anticipation of QE3. But another reason for the price decline could be an assessment that the global economy is slowing and the current size of QE3 is inadequate to create strong enough global growth. According to the IMF head Christine Lagarde "We continue to project a gradual recovery, but global growth will likely be a bit weaker than we had anticipated even in July, and our forecast has trended downward over the last 12 months." The forecast takes into account the Federal Reserves QE3 program announced 11 days earlier.

The Federal Reserve has a dual mandate of stable inflation and full employment. In order to help boost employment the Fed announced QE3 with this statement "to support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. These actions, which together will increase the Committee's holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative."

By launching QE3 the Federal Reserve is not only hoping to see an increase in employment, it is also hoping to see an uptick in inflation expectations back to its 2% target. Higher inflation helps to create demand because it is better to buy a product one needs or wants today than to wait and pay a higher price tomorrow. Other than housing and wages, there is no more important input into inflation than the price of oil. Although the CPI calculates inflation with an ex-Food and Energy component, the increase in oil prices filters into many goods that use oil or need transportation that are not part of the ex-Food and Energy CPI calculation but are part of the Core CPI. The decline in oil prices could be signaling that the markets believe despite creating an extra $40 billion a month, it is not enough to raise inflation expectations sufficiently to stimulate demand enough to offset all of the headwinds the economy is facing.

The Federal Reserve has left QE3 open ended with a periodic review to increase or decrease the size of the asset purchases. A further decline in oil prices could lead the Federal Reserve to raise the size of its asset purchases with new money above $40 billion. While oil has fallen since the announcement of QE3, gold has risen in price and held its gains. This could indicate the best way to benefit in an increased round of QE3 is with gold and not oil. Rather than investing in an oil ETF like the United States Oil Fund (NYSEARCA:USO) investors could purchase the SPDR Gold Trust (NYSEARCA:GLD), or buy a gold mining company like Newmont Mining (NYSE:NEM), Barrick Gold (NYSE:ABX), GoldCorp (NYSE:GG), Anglico Eagle Mines (NYSE:AEM), or Yamana Gold (NYSE:AUY). At this point it seems the price of gold is being driven more by Fed expectations and the price of oil is being driven more by expectations of the economic outlook.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Stocks: ABX, AEM, AUY, GG, NEM, USO, GLD