The Federal Reserve Bank’s August 10 Federal Open Market Committee (FOMC) meeting announcement and other news emanating from the Federal Reserve Bank chairman and governors are anxiously followed by economists and investors as they attempt to determine the direction of the American economy and markets. The United States is at a pivotal point where the decisions of the Federal Reserve Bank are going to be of enormous importance for the direction of US and world stock markets and the price of commodities including precious metals and oil.
It is increasingly apparent that economic recovery in the United States is stalling. Quantitative easing in the form of $1.5 trillion official and 4 to 5 trillion dollars unofficial deficits by the United States Government have not been sufficient to stimulate an economic recovery. Money has flooded into the banking system, however, consumers and businesses have not been borrowing thereby depressing an important component of the money creation process. As a consequence, money supply contracted year-over-year as debt default outpaced new money creation. These developments have led many to speculate that a new round of quantitative easing is on the way to fight the deflationary forces at work.
In late July, the president of the Federal Reserve Bank of Saint Louis, James Bullard, released a paper he authored entitled -Seven faces of “The Peril”-
http://research.stlouisfed.org/econ/bullard/pdf/SevenFacesFinalJul28.pdf
in which he argued that the United States was maneuvering into a Japanese style deflationary outcome in the next few years. Bullard supported further stimulus, stating unambiguously that: “the quantitative easing program offers the best tool to avoid such an outcome”.
The timing and directness of Bullard’s statements, we believe, were not offered to the public without the blessing of Federal Reserve Chairman, Ben Bernanke. We believe further that the Federal Reserve Bank is indeed signaling more quantitative easing – QE2 - through these statements and the markets seem to be interpreting them as evidence that quantitative easing is on the horizon. More recently, the August 10 Federal Open Market Committee meeting statement regarding Federal Reserve Bank’s interest rate policy hinted of further easing. The Federal Reserve Bank kept interest rates steady, and the all important language of their statement indicated that the Federal Reserve Bank would no longer drain reserves from their balance sheet by stating: “To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.” Here the Federal Reserve has announced a reversal of policy and one that takes a step in the direction towards renewed quantitative easing. They now recognise weaknesses in the economy. One should not expect the Federal Reserve Bank and its governors to do anything more than take small gradual steps in the direction that they are moving their policy, however, it seems clear that QE2 is the direction that they are headed with actual announcements slated for as early as this fall.
If the markets have interpreted the Federal Reserve Bank statements as we have, a floor should now be in place providing support for the commodities markets, especially precious metals. That is, the price of commodities, particularly oil, gold and other precious metals, should have bottomed out. Several weeks ago, we cautioned in this column that gold and precious metals were likely to experience a significant correction, and indeed this is what has happened. We believed that a correction could last as long as early October, however, based on the information provided here we now believe that it is more than likely that this correction ended in July when Bullard’s paper was released. The third week of August remains a possibility for a low as this week often marks a summer low for precious metals.
The stock market will have a tougher time than commodities. The weakening economy will not bode well for pricing stocks more richly. However, liquidity if provided in sufficient quantity will ultimately drive stocks higher. Stocks may have to wait for actual injections of liquidity to move higher and are therefore susceptible to a decline in the early fall.
In a future article, we will explore the consequences of a second round of quantitative easing. The impact of a QE2 will be felt worldwide in terms of commodities, stocks and currencies.
* With contribution from Bruce H. Pugesek, President of Voyageur Research
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