There was a time when price stability and well-behaved indicators of inflation would send gold prices lower. After all, many investors and savers typically buy and hold gold as an inflation hedge. With little inflation in sight, prospective buyers would not be expected to stock up on the yellow metal . . . and some might even wish to reduce their bullion holdings.
Uncharacteristically, today’s news that U.S. producer prices were flat in July sent gold prices up more than $12 an ounce in New York trading.
That’s because, Chairman Ben Bernanke and his fellow policymakers at the Fed are worried that near-zero inflation could morph into a full fledged deflation that, in turn, would seriously hinder economic growth and worsen labor-market conditions.
The absence of inflation — or, worse yet, deflation — is worrisome to the Fed because it encourages businesses and households to postpone spending in the expectation that lower prices lay ahead. And, less spending means less economic activity and higher unemployment.
Along with its 6.5 percent unemployment target, the Fed is also targeting consumer price inflation, which it would like to see running at 2 percent year over year. ??With both producer and consumer price inflation running well below target and unemployment running above target, the Fed may not only find it difficult to taper its monthly bond purchases (now running at $85 billion per month), it may feel compelled to boost its monetary stimulus to prevent inflation from decelerating further – or, worse yet, lapsing into a full-fledged deflation.
Many Fed watchers and financial-market traders had been expecting the Fed to begin reducing its economic stimulus program as early as September or, at least, announce a start date following its September FOMC policy-setting meeting.
In April, when Bernanke hinted that a reduction in monetary stimulus could begin later this year, gold-traders panicked and gold prices fell precipitously. We may soon be looking at the opposite situation if expectations move in the opposite direction.
Should there be more economic news in the next few weeks that would make it difficult for the Fed to begin gradually reducing its monthly bond purchases as early as September, gold prices could rally smartly, rising in the weeks and months ahead more than even many gold-friendly analysts and investors now expect.
Earlier this month, in our August 4th communication to clients and subscribers, we made the following points that are worth repeating:
- The risks of a major lasting downward gold-price correction are significantly less than the possibility of a quick bolt into higher territoryand the re-establishment of the long-term bullish trend.
- We sense that the U.S. economy is weaker than generally believed – and certainly not strong enough to bring real improvement to the jobs market and real relief to the unemployed, under-employed, and under paid. Moreover, the recently reported and prospective inflation data are running well below the Fed targets.
- As we move into autumn, expectations of early Fed tapering should diminish, putting gold on a firmer footing.
- Continuing gridlock in Washington – as the Federal debt limit approaches – could cause businesses and households to cut back on spending and weaken the U.S. dollar in world currency markets.
- At the same time, better-than-expected overseas economic indicators — from Europe, China, and other emerging-economy nations — should also weigh down the dollar to gold’s advantage.