Gold prices have fallen about 3.5% over the last week, mostly on deflation fears. Gold prices typically get hit in the short run when people are worried about the economy. The reason gold prices fall is because gold is typically seen as the anti-inflation asset, though this is probably an oversimplification of gold.
Gold prices will likely stay flat or continue to fall if deflation fears pick up and there isn’t an equal belief that the government of the US will do something inflationary on some level, like another round of QE. To understand what’s happening, we first need to understand Operation Twist.
What is Operation Twist?
Like I wrote two days ago, the Federal Reserve has essentially decided to manipulate interest rates down lower than they are. The goal is to “help” the economy by manipulating the price of credit to get people to spend and/or invest more money. Mortgages, car loans, business loan — lower interest rates should, in theory, help spur on loan creation.
This, in turn, will mean more money flowing around in the economy. This is a pretty strong oversimplification, but it’s how it all works in general. The impact to the economy isn’t instant, but it does have a pretty strong impact to investor expectations. Stocks are generally helped quite a bit by manipulated interest rates.
The big news of the last week, however, is that there was no new round of QE. Operation Twist was just extended for the rest of the year, and that means that the news wasn’t nearly as strong as some thought. Why is there no QE3 when the economy is doing so poorly? Good question.
Is the Fed Running Out of Bullets?
Basically, yes. The recent “Operation Twist” is just an attempt to push interest rates lower, and overall isn’t too much of an inflationary pressure, if it is at all. The Richmond Federal Reserve chief dissented to the Federal Reserves decision to continue Operation Twist, saying the following:
“I dissented on this decision because I do not believe that further monetary stimulus would make a substantial difference for economic growth and employment without increasing inflation by more than would be desirable. While the outlook for economic growth has clearly weakened in recent weeks, the impediments to stronger growth appear to be beyond the capacity of monetary policy to offset.”
He is, of course, right. Overall, the Federal Reserve really doesn’t have too many tools asides from literally just buying stuff — actually things from the market — to spur demand. If they do that, well, hopefully you’ll own a lot of gold because things will get hairy fast.
As of right now, the Federal Reserve is just buying long-term bonds and selling-short term bonds with the goal of manipulating interest rates to fall in the short run even further. In theory, this should help spur on demand for new credit, but so far this has been mostly unsuccessful. Interest rates have continued to fall, however, and will likely keep falling for some time. I’ve written a bit about interest rates at my interest rate website.
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