The Bernanke Fed:
Hawks or Doves?
Central banks across the globe are raising
interest rates to stem the flow of cheap money into
the economic system to fight inflation that is rising
above comfortable 2-3% benchmark levels. The
Federal Reserve Bank of the United States has
raised interest rates 17 consecutive meetings to
over 5%. Now, for the first time in nearly a
decade, the Bank of Japan has raised interest rates
a quarter point and has set the stage for further
rate increases moving forward.
At the same time, the governments of China,
Canada, India, the European Central Bank and
other countries across the globe are raising rates to
slow economic growth and combat inflation.
The Trick Is Figuring out When Is Enough, Enough?
No country wants their currency to challenge the
US Dollar as the global reserve asset because of what
it would mean to their trade deficits. But, at the same
time, the deficits and trade imbalances being run by
the US government are eroding the overall worth of
the greenback. The Euro and
the Yen are not strong enough
currencies to absorb all of the
flight from a weakening dollar,
which opens the door for gold
to reassert itself as the fourth
global currency.
“It is difficult, if not impossible, to recall a time when
so many central banks were so crystal clear about
their desire to withdraw liquidity from the system.
As always when leveraged investors are invited to
the party, everyone thinks they can be first out of
the door when they hear the chimes at midnight.”
—Tim Price, a strategist at Union Bancaire Privee 6/20/06
Recent language by the
Fed suggests that they are ready
to end rate hikes or, at the very
least, see the end coming soon.
It is a fine line to be forced
to walk. On one hand the
Fed needs to sound hawkish
on rising inflationary
pressures (being led mostly
by energy prices which will
eventually flow throughout
the entire supply chain),
while at the same time being
careful not to tighten too
much and send the economy into a recession. The possibility of stagflation sits on
the horizon should the Fed rate decisions not be able
to combat macroeconomic trends.
“GOLD IS EMERGING AS A FOURTH GLOBAL
CURRENCY. We regard gold as an essential barometer
in the grand battle between hard and financial assets,
which has strongly favored commodities and real estate
over the past three years. Gold should be well
positioned if the US economy slows sharply, given debt
and dual-deficit strains that would likely emerge, or if
the Fed attempts to reflate its way past near-term
growth impediments. Citigroup economists remain
concerned over global macro imbalances. Refreshingly,
however, it no longer seems necessary to be a ‘caned
food-and-crossbows’ gloom-and-doomer to believe
in gold.”
—Citigroup 1st quarter 2006
Up until the 1970s, it was generally believed
that recession and inflation could not occur at the
same time. A slowing economy was supposed to
bring stable prices; so inflation just could not be a
problem when the economy slowed. That belief gave
central bankers, such as the US Federal Reserve, a
sure-fire method for combating high inflation by
employing tight monetary policies until inflation was
choked off. The oil crisis of 1973 shattered that
myth and resulted in a new word in financial
circles: Stagflation.
Stagflation is a 4-letter word on Wall
Street because, once it takes hold, it is
very difficult to correct. Fiscal and
monetary policies aimed at stimulating the
economy only exacerbate the inflationary
aspect of stagflation. Tight monetary
policies, on the other hand, amplify the
stagnating effect of high energy prices.
For instance, manufacturing is currently
falling into a recession, while the service
sector of the economy is growing. This
has the effect of showing some growth and
some weakness while not giving
government economists a clear picture of
which direction the economy is currently
headed.
“One of the most significant aspects of financial globalisation has been the extremely rapid
expansion of international liquidity. The enormous increase in liquid assets available to
international market participants is worrisome for several reasons: it erodes central banks’
ability to exercise monetary control; it triggers potential inflationary pressures that could
easily be triggered if expectations change; finally, it facilitates the opening of speculative
positions and may cause the quality of credit to decline. These last two channels can create
instability in the financial and real markets.”
—Bank of International Settlements position paper on global liquidity by Fabio Fornari and Aviram Levy
Should the Fed stop hiking rates
while other countries around the globe
continue raising rates or, as in the case of
Japan, have just begun raising rates, gold
and precious metals will be in the
ultimate sweet spot for rapid growth as
we enter the third and fourth quarters of
2006. Uncertainty surrounding reserve
asset allocation and competent monetary
policy will lead to countries returning
en masse to the ultimate reserve
asset...GOLD.
