Gold and The 2% Factor
Former Fed economists that I have heard speak indicate that the Fed, after running lots of simulations and models, has an ongoing, implicit 2% target for inflation. You can see their current thinking in the latest FOMC minutes. It feels it needs that much inflation to meet its dual mandate. Over the last year its greatest fear is that at inflation rates below 2% it is too easy to tip the economy into deflation. This would have disastrous effects on some critical U.S. asset classes, namely residential and commercial real estate. Right now we have negative inflation with no clear trend higher. So the Fed is more worried about deflation than inflation currently.
There are only two ways to create inflation and they are related. Increase the money supply faster than trend nominal GDP growth and devalue the dollar. The Fed has already done #1 and short term interest rates are close to zero. They can’t go any lower. So it has now moved onto strategy #2, devalue the dollar. I don’t see any policy makers that are thrilled with the current state of the dollar. And I hear a lot of commentary that implies the Fed is driving down the dollar just because it is stupid or inept or to help the manufacturing sector or to help autos. Those are all red herrings. It is worried about deflation taking hold.
What does all this mean? The dollar will be under pressure until the Fed can see inflation hitting at least 2%. Right now 2% is at the high upper range of the most recent set of Fed staff estimates. Gold, silver, most industrial metals and other currencies will be headed higher. I expect gold or GLD, SLV to get pretty frothy before the major trend changes.
NOTE: This does NOT mean selling the dollar is a risk free trade. In fact, it is getting to be quite a crowded trade. The dollar is quite oversold now. We could have one or more sharp 10% or so reverses in the dollar that will make people think the dollar is done going down. But until inflation is a sustainable 2% the dollar will be under pressure and gold will head higher.
