Is The Fed Finally Losing Its Credibility?

With Wednesday's data release that showed that the increase in "core" CPI in January was higher than expected, the price of gold soared by over $20 per ounce to just shy of $680 per ounce, a new nine-month high. As this is the reaction that most market watchers would have expected, it is not surprising that these movements failed to inspire much interest. After all, gold is an inflation hedge, so any sign that inflation is worsening should be positive for gold prices. However, what is surprising is that this is one of the few recent occasions when the gold market has actually behaved logically in this regard. Could it be that some whiff of sanity has arrived on Wall Street?

Over the last few years, the price of gold has typically declined following larger than expected jumps in "core" consumer prices. These counter intuitive movements have been explained by the market's anticipation that the Fed would react to higher inflation with additional rate hikes. Since higher interest rates are typically bearish for gold, the metal has dipped on signs of elevated inflation. However, Wednesday's $20 surge indicates that something meaningful may have changed.

My guess is that the market is calling the Fed's bluff. Gold investors may have finally concluded that when it comes to fighting inflation, the Fed is all bark and no bite. Despite the tough talk, many are now convinced that Bernanke will not risk pushing the U.S. economy into recession in an effort to contain inflation. With the sub-prime mortgage market unraveling, the last thing the Fed wants is to add kerosene to the fire in the form of higher interest rates. If gold investors now believe that the Fed will tolerate higher inflation, then any signs of heightened inflation can now be seen as purely bullish for gold.

This is an extremely significant development with profound implications for U.S. financial markets, particularly long-term bonds, the housing market, and the entire U.S. economy. If investors are finally wising up to the Fed's bluster, a run on the dollar can not be too far off. To maintain international confidence in our currency, the Fed must be credible in its resolve to fight inflation. If our foreign creditors decide that "Helicopter" Ben is more concerned about keeping housing prices up than he is about keeping consumer prices down, they will rush for the exits.

I think we are fast approaching the time when the markets will actually force the Fed to show its cards. If gold prices continue to surge (up another ten bucks so far this morning,) and long-term interest rates finally follow suit, the Fed will be forced to make a very uncomfortable decision. It will either have to raise rates aggressively, and let the economic chips falls where they may, or fold its hand by leaving rates unchanged. Either way, we are in big trouble. If the Fed does the former, stock and real estate prices will fall, dragging the economy and the dollar down with them. If it does the latter, the dollar will collapse, long-term interest rates will soar, causing stock and real estate prices to plunge, and pushing the economy into recession. It's the ultimate catch-22. When it comes to the Fed raising rates, we're dammed if they do and dammed if they don't.

On a somewhat related note, the current Wall Street bull market hype ignores the fact that all the major stock market averages are underperforming the price of gold. For example, year to date, while the Dow is up about 1.5%, the price of gold is up about 8%. Going back to January of 2000, while the Dow is only up about 15%, the price of gold price is up 150%, literally ten times as much. Even if you compare the Dow to gold starting from the Dow's October, 2002 low of about 7,200, the Dow is up about 75% verses 125% for gold. Call me crazy but how can we be in a bull market if investors are making more money owning gold than owing stocks?

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