Why you should be nice to your mom - and buy some gold

Thanks to the flood of liquidity generated by the US' QE-3 and the ECB's bond buying plans, gold will get a boost.

Vivek Kaul September 15, 2012 13:15:21 IST
Why you should be nice to your mom - and buy some gold

So Ben Bernanke, the Chairman of the Federal Reserve of the United States (the American central bank) has proven me wrong.

In a recent article, I wrote that the Federal Reserve would not initiate a third round of quantitative easing (QE-3) before the 6 November presidential elections in the United States. (You can read about it here.

Bernanke announced on Thursday night that the Federal Reserve would buy mortgage-backed securities worth $40 billion every month. This will continue till the job scenario in the United States improves substantially. The Federal Reserve will print money to buy the mortgage-backed securities.

Why you should be nice to your mom  and buy some gold

Gold shine. Reuters

I concluded that the Federal Reserve wouldn't announce any QE till 6 November primarily on account of the fact that Mitt Romney, the Republican nominee for president, has been against any sort of QE to revive the economy.

"I don't think QE-2 was terribly effective. I think a QE-3 and other Fed stimulus is not going to help this economy... I think that is the wrong way to go. I think it also seeds the kind of potential for inflation down the road that would be harmful to the value of the dollar and harmful to the stability of our nation's needs," Romney toldFox Newson 23 August. This had held back the Federal Reserve from initiating QE-3.

But from the looks of it Bernanke doesn't feel that Romney has a chance at winning and that he is more likely than not going to continue working with Barack Obama, the current American president.

This round of quantitative easing is going to help Obama and hurt Romney. Let me explain. The theory behind quantitative easing is that when the Federal Reserve buys mortgage-backed securities (in this case) by printing dollars, it pumps in more money into the economy. With more money in the economy, banks and financial institutions, it is felt, will lend that money and businesses and consumers will borrow. This will mean that spending by both businesses and consumers will start to rise. Once that happens the economic scenario will start improving, which will lead to more jobs being created.

But, as I said, this is the theoretical part. And theory and practice do not always go together. Both American businesses and consumers have been shying away from borrowing. Hence, all this money floating around has found its way into stock and commodity markets around the world.

As more money enters the stock market, stock prices go up and this creates the "wealth effect". People who invest money in the market feel richer and then they tend to spend part of the accumulated wealth. This, in turn, helps economic growth.

As Gary Dorsch, an investment newsletter writer, said in a recent column, "Historical observation reveals that the direction of the stock market has a notable influence over consumer confidence and spending levels. In particular, the top 20 percent of wealthiest Americans account for 40 percent of the spending in the US economy, so the Fed hopes that by inflating the value of the stock market, wealthier Americans would decide to spend more. It's the Fed's version of "trickle down" economics, otherwise known as the "wealth effect".

When this happens, the economy is likely to grow faster and hence, people are more likely to vote for the incumbent president. As Dorsch explains, "Incumbent presidents are always hard to beat. The powers of the presidency go a long way.... In the 1972 election year, Nixon pressured Arthur Burns, then the Fed chairman, to expand the money supply with the aim of reducing unemployment, and boosting the economy in order to insure Nixon's re-election."

Bernanke is looking to do the same, even though he has denied it completely. "We have tried very, very hard, and I think we've been successful, at the Federal Reserve to be non-partisan and apolitical.... We make our decisions based entirely on the state of the economy," the Financial Times quoted Bernanke as saying. Given this, Romney has been a vocal critic of quantitative easing knowing that another round of money printing will clearly benefit Obama.

Other than Obama and the stock markets, the other big beneficiary of QE-3 will be gold. The yellow metal has gone up by around 2.2 percent to $1,768 per ounce, since the announcement for QE-3 was made. In fact, the expectation of QE-3 has been on since the beginning of September after Ben Bernanke dropped hints in a speech. Gold has risen by 7.3 percent since the beginning of this month.

This is primarily because any round of quantitative easing ensures that there are more dollars in the financial system than before. The threat is that the greater number of dollars will chase the same number of goods and services. This will lead to an increase in their prices. But this hasn't happened till now. But it hasn't stopped investors from buying gold to protect themselves from a further debasement of money. Gold cannot be debased. Unlike paper money it cannot be created out of thin air.

During earlier days, paper money was backed by gold or silver. When governments printed more paper money than the precious metals backing it, people simply turned up with their paper at the central bank and government mints, and demanded that paper money be converted into gold or silver. Now, whenever people see more and more of paper money being printed, the smarter ones simply go out and buy that gold. Hence, bad money (that is, paper money) is driving out good money (that is, gold) away from the market.

But that's just one part of the story. The governments and central banks around the world, led by the Federal Reserve of United States and the European Central Bank, are likely to continue printing more money, in the hope that people spend this money and this revives economic growth. This, in turn, increases the threat of inflation which would mean that the price of gold is likely to keep going up. "Gold tends to benefit from easy-money policies as investors utilise the precious metal as a hedge against potential inflation that could ultimately result from the Fed's policies," Steven Russolillo, wrote on WSJ Blogs.

Market watchers have also started to believe that the Federal Reserve is now only bothered about economic growth and has abandoned the goal of keeping inflation under control. Growth and inflation control are typically the twin goals of any central bank.

"They are emphasising the growth mandate, and that means they don't care about inflation other than giving lip service to it," Axel Merk, chief investment officer at Merk Funds, told Reuters. "The price of gold will do very well in the years to come," he added.

Something that Jeffrey Sherman, commodities portfolio manager of DoubleLine Capital, agrees with. "The Fed's inflationary behaviour should be bearish for the dollar in the long run and drive investors to seek protection via the gold market," he told Reuters.

Also unlike previous two rounds of money printing, there are no upper limits on this QE, although at $40 billion a month it's much smaller in size - but may continue indefinitely. QE-2, the second round of money printing, was $600 billion in size.

Something that can bring down the returns on gold in rupee terms is the appreciation of the rupee against the dollar. Yesterday, the rupee appreciated against the dollar by nearly 2 percent. This is happening primarily because the UPA government has suddenly turned reformist. (To understand the complete relationship between rupee, dollar and gold, read this).

In the end let me quote William Bonner & Addison Wiggin, the authors of Empire of Debt - The Rise of an Epic Financial Crisis. As they say, "There is never a good time to die. Nor is there a good time for a crash or a slump. Still, death happens. Be prepared. Say something nice to your mother. Offer a bum a drink. And buy gold."

So be nice to your mother and buy gold.

Vivek Kaul is a writer. He can be reached at vivek.kaul@gmail.com.

Disclosure: He has investments in gold through the mutual fund route.

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