The Dreaded "Tapering"

It seems that every year a new word or term or acronym becomes a prominent part of the financial world's lexicon. Examples from previous years are "irrational exuberance", "Asian tiger", "productivity miracle", "Greenspan put", "goldilocks economy", "commodity supercycle", "savings glut", "Fiscal Cliff", "BRIC", "PIIGS" and "QE". Right now, the term of the day is "tapering", as related to the Fed's plans to scale back the magnitude of its "QE".

There is no doubt that the Fed will eventually have to not only "taper" QE, but also stop it completely and go into reverse. The alternative would be to destroy the currency and the economy via hyperinflation. However, it's not reasonable to refer to the inevitability of reduced monetary accommodation as a plan. We aren't dealing with master strategists; we are dealing with bungling bureaucrats who are constantly reacting in knee-jerk fashion to financial-market and economic events that they never see coming. Something happens and the Fed reacts. The reaction distorts prices and leads to unintended consequences, prompting another Fed reaction, and so on. In other words, although the Fed may well talk about an "exit plan", it actually has no clue what it will do in the future. What it does will be dictated by events it can't predict.

As an aside, it should be understood that over the long-term it wouldn't matter if the top echelon of the Fed was populated by master strategists, the Fed would still end up making a mess if it attempted to improve the economy by manipulating interest rates and money supply. It should also be understood that the Fed doesn't exist to improve the economy; it exists to remove financial obstacles from the growth of the government and the banking industry.

We now turn to the relationship between the gold market and "QE tapering". Although talk of the Fed's QE tapering has caused significant short-term fluctuations in the gold price and will no doubt continue to do so, the gold price is likely to embark on a major advance from this year's low almost regardless of what the Fed does from here on. The reason is that the damage (the basis for the next major gold advance) is already in place thanks to the QE that has happened up until now. What we've seen, to date, are the positive effects that almost always appear during the initial phase of a monetary expansion. These initial positive effects are why monetary inflation remains popular with the masses despite its debilitating long-term consequences. Unfortunately, it is never possible to know ahead of time how long the positive initial phase will last. What we do know is that just as surely as night follows day, the negative consequences will eventually rise to the surface. Gold benefits from these negative consequences of monetary inflation rather than the monetary inflation itself.

Now, the most widely known negative consequence of monetary inflation is "price inflation" (a reduction in the purchasing power of the money). However, "price inflation" is not the most important negative consequence. Of far greater importance is the distortion of RELATIVE prices caused by the monetary inflation, because it results in widespread mal-investment and an economy that experiences slower real progress on average and larger long-term growth oscillations. Regardless of when problematic "price inflation" is destined to emerge in response to the Fed's aggressive monetary accommodation, the US economy has already been seriously weakened by the price distortions stemming from past QE and at least some of these weaknesses are likely to become apparent before the end of this year.

From our perspective some of the weaknesses are already obvious. For example, rather than invest in new manufacturing plant and business expansion, the flood of new money has prompted many listed US corporations to pay high prices for their own shares. This has helped to push stock prices upward despite minimal earnings growth, no revenue growth and a persistently high level of unemployment (about 15% if measured correctly). It seems, though, that the weaknesses will have to become clearer before they are seen/appreciated by the average investor. When that starts to happen the next major advance in the gold price will get underway, even if the Fed happens to be "tapering" at the time.

The above is excerpted from a commentary originally posted at www.speculative-investor.com on 16th June 2013

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