But Do They Mean It? Bearish on the Feds Resolve
"The quantity of money available in the whole economy is always sufficient to secure for everybody all that money does and can do" - Ludwig von Mises, Human Action p. 418.
The top news of the week is the change in Fed Chairman Ben Bernanke's language with regard to dealing with the subject of inflation. In past reports, I'd responded to the claim that the Federal Reserve was actually tightening by writing, before the Fed can fight inflation it has to acknowledge it. Up until now the central bank has been taking its foot off the gas pedal but it has not been stepping on the proverbial brakes. This was evident in the language of the Fed - as the aim of its current policy was merely to 'remove' accommodation, and target a "neutral" interest rate level.
But this all changed yesterday. Following on Micheal Moskow's warning of last week, Bernanke too warned of the risks of letting the price increases that have been making their way through the Fed's statistical filters become embedded into the psychology of market participants, and thus he brought this particular risk to the forefront of policy action and reaffirmed his and his colleagues' commitment to the policy of price stability - relevant excerpt below:
"Given recent developments, the medium-term outlook for inflation will receive particular scrutiny. There is a strong consensus among the members of the Federal Open Market Committee that maintaining low and stable inflation is essential for achieving both parts of the dual mandate assigned to the Federal Reserve by the Congress. In particular, the evidence of recent decades, both from the United States and other countries, supports the conclusion that an environment of price stability promotes maximum sustainable growth in employment and output and a more stable real economy. Therefore, the Committee will be vigilant to ensure that the recent pattern of elevated monthly core inflation readings is not sustained... In addition, the Committee must continue to resist any tendency for increases in energy and commodity prices to become permanently embedded in core inflation. The best way to prevent increases in energy and commodity prices from leading to persistently higher rates of inflation is by anchoring the public's long-term inflation expectations. Achieving this requires, first, a strong commitment of policymakers to maintaining price stability, which my colleagues and I share, and, second, a consistent pattern of policy responses to emerging developments as needed to accomplish that objective. Our economy has reaped ample rewards in recent years from the achievement and maintenance of price stability. Although challenges confront us, as they always do, I am confident that we will be able to preserve those hard-won benefits while promoting sustainable economic growth" - Fed Chairman Ben Bernanke, June 5th.
Combined with recent moves at the US Treasury this indicates a significant change in attitude at the helm. It is undoubtedly a reaction to signs of renewed currency stress in recent months; but it is also a matter of shoring up confidence in the new leadership at the Fed, which has appeared overtly dovish since Bernanke took over, underpinning the biggest commodity rally in decades. It is the necessary first step in order to prevent price increases from becoming "permanently embedded."
For, as Mises remarked, should inflation become psychologically embedded...
"But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against "real" goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap pater. Nobody wants to give away anything against them. It was this that happened with the Continental currency in America in 1781, with the French mandats territoriaux in 1796, and with the German Mark in 1923. It will happen again whenever the same conditions appear. If a thing has to be used as a medium of exchange, public opinion must not believe that the quantity of this thing will increase beyond all bounds. Inflation is a policy that cannot last" - Ludwig von Mises, Human Action, Chapter 17
The "crack up boom" is basically his term for hyperinflation.
At least in the context of the message the Fed is sending they appear to be more serious about shoring up the USd and capping general price increases than at any other time this millennium.
But it's one thing to display resolve while all is fine on Wall and Bay Street. When stocks really start reeling it'll be difficult to continue the policy of hiking rates in order to fight inflation; and when the Fed instead pauses, or eases again, Bernanke will simply tell us that the weakening economy will be the cure all for inflation pressures, all the while having the pedal to the metal if you will.
We saw by the action in the markets that they have not factored in a genuinely inflation-fighting Fed. The easing plays have been dominant for the better part of the past year. The market is used to being told that the Fed is fighting inflation but that inflation is not particularly a problem.
[Our readers must know that the Fed is no stranger to self-contradiction!]
Now the Fed is telling us that the economy is strong enough to withstand an inflation fighting campaign, and that in any case, it has become a priority - the risks of inflation now outweighing the risks of a slowdown in terms of the central bank's dual mandate of blah-blah-blah and blah.
I think they mean it at the moment, but I also believe that their resolve will prove very fickle when the impact of this new policy, if that's what is emerging, begins to manifest in falling stock prices - triggering Bernanke's deflation phobia. I don't believe that the Bernanke Fed has the stamina or chutzpah to embark on and sustain an inflation fighting campaign throughout an asset crunch.
Evidently, the price and currency trends are making the Fed and Treasury nervous, but I doubt they are committed to anything beyond the lip service they are paying to their critics' concerns.
Thus the case could be made for this change in policy to backfire on the Fed, but it depends on: 1) whether it leads markets to suddenly realize that this inflation thing is more important than they've been led to believe (so they sell their bonds and flock to gold); and/or 2) the hypothesis that stock values plummet because the economy is not as resilient as Bernanke presumes.
In the latter situation, the question arises whether the inflation trade (gold) could buck the general trends. Clearly, the answer depends on how the central bank would respond to plummeting stock and bond values and the concomitant general deterioration in the stream of economic data.
In the current environment where asset values (i.e. PE ratios) are still generally expensive, where gold is still significantly undervalued, where the hotbed of potential geopolitical catalysts is getting deeper and hotter, and where the progressive government and its populace have become all but addicted to the inflationary doctrines as a source of boom times, we have no choice but to remain fundamentally bullish on the inflation trade and gold, and hence bearish on the Fed's resolve.
Fundamentals aside, moreover, while the intermediate trend sequence that kicked off last June in gold has been stronger and lasted longer than originally expected, I've said all along that the final buying spike in my outlook would occur on a meltdown in stocks generally. Specifically, I have been looking for a rollover in the general stock market uptrend that began in 2003 to result in just what we are seeing now - one last ST correction in the gold sector (concomitant with declines in all the other equity sectors that have been advancing along with gold over the past few years) as a knee-jerk reaction, then a final move to higher highs before the real correction starts. What's more, it has been my (written) contention that the historical purpose of this advance in gold prices all along was to prompt the central bank into action... that it would continue to appreciate until the central bank decidedly targeted inflation in other words. So here we are, except that the central bank has yet to back up its resolve. In my opinion, it can only afford this resolve to the extent that stock prices hold up and no one breaks the nervous peace before the next presidential election.
Gold Market Outlook
Following Bernanke's appointment, and up to last week, there's been a strange dearth of bearish facts to worry about outside of the recent volatility. This has changed now with Hank Paulson potentially taking over the task of carrying out US dollar policy and with the belated arrival of hawkish overtones at the Fed... the bears have finally made it to the ball game! But the substance of their potential bearishness is limited by the extent of their resolve. In the Fed's case, resolve amounts to tightening the screws even as asset prices fall and unemployment rises, if necessary. As far as the Secretary Treasury, his main job is to put a friendly and confident face on the currency, but he cannot postpone indefinitely the consequences of his own home made inflationary policies.
The value of an inflation prone currency will invariably fall. The US Treasury's most significant current challenge with regard to US dollar policy is to smooth over relationships with those trading partners whose willingness to continue to finance the US budget and trade shortfalls has met with increasing reluctance, and who have indicated a preference to diversify out of their surplus dollar holdings, which in turn has far-reaching implications for the dollar's status as THE global reserve.
The job of how much the currency eventually depreciates is ultimately the Federal Reserve's.
After Robert Rubin's resignation in 1999, the job of Treasury Secretary fell first to an economist then a bureaucrat, then a corporate manager, all of whom were not generally considered as market savvy as Rubin himself, though it could be argued that they came in at a bad time and that not even Robert Rubin could have forestalled the subsequent demise in the real and foreign exchange value of the currency (any longer). But this is the first time since Rubin's departure that an apparently market savvy individual has considered accepting the position (coming from the same firm), which speaks volumes in of itself. It suggests, at least, that the smart money thinks that it may be safe to wade back in on the buy side of this currency now. On the other hand, it could signify the knowledge of certain possible events - a premeditated bear raid on gold, or a pre-emptive defense measure to ward off the inevitable currency crisis that has drawn ever near.
I think the market should indeed take notice that something is afoot, and we may not know what yet. However, as I've pointed out, I believe that much of its success depends on the Federal Reserve's newfound resolve from here on out, and I don't think they've really got it because I believe that they are underestimating the global economy's dependence on growing "liquidity."
Technically, neither gold nor the gold shares have embarked on an intermediate correction - both the HUI and gold prices themselves remain above the technical parameters which I set out in our last update as sustaining the intermediate advance that began last summer. Gold could fall to the US$580 level and the intermediate sequence would still be valid; a fall through there, however, would qualify as the onset of an intermediate correction. But the genuine reversal point is the last highest low in the intermediate sequence, which is the Feb/March low (approximately US$550 on the nearest COMEX contract). Thus technically the intermediate sequence is supported down to US$550. The similar parameters that I had set out for the HUI (AMEX Gold Bugs Index - equity) were between 280 and 300. In other words, 300 is normal (intermediate) trend support, but 280 is worst case trend support as it is the last highest low in the sequence that began last summer.
Meanwhile, bearish technical developments have increasingly surfaced in the charts of some of the other metals and commodities in recent weeks, the gold shares are trading poorly, and the general stock averages have continued to set off sell signals on the charts. The long and short of it is that I am allowing the market some two-way (elbow) room, and am skeptical of the substance behind the bear raid. If the market falls through the parameters that I have set out above, it could then be called an intermediate correction. The most bearish near term fundamental fact would be that I underestimated the stock market's general resilience to any display of resolve. However, the way that it is responding suggests that the early evidence is in and says we're probably right.
Therefore, I remain bullish for one more high before the primary liquidation that I've warned about comes into full view. I would not rule out an intermediate correction but it is important to realize that technically one hasn't begun yet. Moreover, I'm not calling for one because I believe that the above parameters will hold, and if not, they will be recovered quickly. My short term outlook is thus neutral to bearish subject to a test of the technical parameters, and my intermediate outlook is steadfastly bullish subject to confirmation of the general market hypothesis and Fed's resolve.