Yogi Berra once said, "When you come to a fork in the road -- take it"!  Well the Fed has come to a fork in the road. Should they take the path of reducing their quantitative easing, or should they increase QE to fight a growing deflationary/recessionary trend developing? Perhaps the price of gold will give some guidance.

Gold rallied last week moving above 1400, but fell back under that psychological level as the week ended. Gold has not been able to mount a sustainable rally. The essential question today for gold investors is why should anyone own gold?  And that, until recently, has been what has been holding it down. Most of the reasons to own gold have one by one been "picked off'. 

"The Fed's printing money so it will cause hyper-inflation". Wrong

"The banking system will collapse". Wrong

"The dollar will crash".  Wrong

"The Dollar will no longer be the world reserve currency". Wrong.

There's more, but you get the point.  Anyone reading this space knows that I have never promoted any of these theories, and in fact have fought against them. In my book, The New Gold Standard, I said right up front in "Why Prices Are Not Skyrocketing" which you can access through this site's commentary archives, that the entire thesis of inflation leading to a total monetary breakdown and collapse was faulty. I have argued vigorously since, that deflation was our greatest threat -- not inflation. And that was in 2008 at the beginning of QE1. Yet I am a gold investor.

So again, why own gold and gold stocks? As a writer on gold for over four decades, I have always advocated owning a certain percentage of your assets in gold and silver coins.  This is an insurance policy against the possibility of a terrible crisis. Today that premise is more in play than ever before. Along with all the economic and monetary Armageddon scenarios we know of, are the cyber-attacks and terrorist attacks that could conceivably close banks, ATM's, and even stock exchanges. In this scenario you would only have the cash in your wallet and your insurance policy -- gold and silver coins. In the future I believe that these threats will grow and so will the demand for gold and silver coins in hand. Add to this fact that governments also have to be concerned about their own ultimate liquidity, and you should have continuous demand as governments continue to be net buyers of gold.  Most do not have enough gold in case of a real emergency -- and they know it. They too need an insurance policy.

The reason to continue to hold resource stocks is the eventual return to world growth. Assuming that this period of world recession and financial turmoil will end at some point, the mere return to 3-4% world growth rates will ensure the continued growing demand for resources. Europe has already broken records for the longest recession in their history, and China has been bumping along at the lowest growth rate they've experienced for over two years now. This period will eventually end.

Meanwhile world population grows. More mouths need to be fed, and more shelters need to be built. And as savings grow with the growth of a new world middle class, gold and silver will be demanded as part of that savings pool. Japan is finally awakening from a two decade economic slumber and will add to the demand for real assets if they go from deflation to inflation. The reason I continue to hold a core position in metals stocks is because I believe the world will grow faster in the future than in the past.

It is world growth and a reversal from a recessionary/deflationary trend to a world-wide prosperity/inflationary trend that is the bull case for gold. I think that predictions of 2000 dollar gold and higher, are unrealistic. I also think that runaway inflation is unrealistic. I believe that more realistically if we can eventually level off in the 1500-1800 dollar area, and metals stocks could double at the minimum under this scenario. Successful junior exploration companies could rise 5 to 10 times in value in some cases.

Where are we in this cycle right now?  We are dealing with fears of Fed tightening in the midst of a deflationary/recessionary trend. This is exactly the wrong direction and gold has signaled this fact. Gold fell as world growth and inflation fell over the last couple of years, but has recently stabilized when the Fed acknowledged that they may increase QE as well as decrease it, if needed. I think that the future data will convince the Fed that QE is not working, and that they will need to take a new and different tact in order to combat deflation, which is the current direction the price index is headed. Gold bounced on that news of possible Fed easing on the 17th of May, and we may have seen the ultimate bottom in both the consumer price index and gold at that time.

Obviously, if the data improves, and employment increases along with GDP then the Fed WILL be able to cut back its bond purchases. If I'm right instead, and the data continues to deteriorate, the odds increase for Fed easing.  This will be good for gold. If the Fed is right and the economy picks up in a sustainable fashion, gold should also stabilize due to increasing wealth, and gold should be under mild accumulation as a form of diversified savings by both individuals and central banks. The tale will be in the data.

However, I think we are in for an important change in monetary policy regardless. Central bank monetary policy is becoming more and more ineffective. As QE has increased world-wide growth has slowed in the US, China, and Europe.  And inflation has declined and even turned to deflation in many areas around the world. If growth is slowing and deflation continues to be a threat, what good is QE? After all, in the euro zone they have 12.2% unemployment and over 40% unemployment among their youth. The answer to the above question is QE appears to be good only to the extent that it prevents runaway deflation and bank runs. Other than that, central banks are impotent to prevent recession or reduce unemployment. That is an obvious fact, and not an opinion.

This is no small matter. If the Fed and other central banks are becoming more and more irrelevant, one of two things must happen.  If all things remain equal, either we descend into a long period of stagnation as Japan has, or the Fed and other central banks must change monetary policy. What to change to is the big question and the answer is not easy. 

But one option, an option that Bernanke most likely does not want to take, is to monetize the debt. Monetization of debt is one way to get money into the hands of people rather than banks where it presently lies dormant. Until now monetization has not occurred and is the main reason we don't have inflation like we did in the 70's. This could change. If Bernanke sees no other way to fight deflation (and remember he is charged with maintaining price stability, which means fighting deflation) he may be forced to choose this option.  Or he may be replaced and the next appointee may do it for him.

Japan is the first central bank that has chosen direct monetization and explicit reflation. The result is that all eyes are on Japan, and is being watched world-wide by other central banks. Monetization as a new monetary policy, which is direct reflation, is a real possibility in a world of recession and deflation. After all, the Fed's explicit inflation target is 2.5% and we are at 1% today.

What happens if in a few months we are at -1% inflation after months of record Fed quantitative easing? The answer is probably reflation -- and gold may be seeing that now.

Watch gold, watch the data as it comes in, and watch interest rates - they may be trying to tell us something. And watch Japan. Japan's stock and bond markets are key indicators world-wide. Any sharp move in interest rates could be signaling future inflation, or concerns about the accumulating debt of nations.  Either way this is just another reason to own gold and why gold may have bottomed and may be on its way back up.

On the flip side we have the negative scenario for gold; and that is that the recessionary/deflationary bias is allowed to become a reality rather than just a potential. There is the possibility that either Europe with its un-united euro zone, or Japan with its 250% national debt to GDP ratio can implode into chaos. Or that the US or China could go from slow growth to negative growth thereby bringing the entire world economy down another notch. We have seen the result of that potential on gold and other commodities over the last two years -- and it’s down.

The world is in a monumental struggle against the forces of de-leveraging, stagnation, recession, and even depression in some areas. Prosperity is the exception, not the rule in the world today.  That’s one reason the US is attracting so much investment funds today. It is at least still profitable.  Near term I fear that the US may join the rest of the world as growth falls along with profits. Certainly any "tapering" of monetary expansion will weigh on the economy and the inflation rate.

As of this writing I continue to hold a small core position in gold, silver and copper stocks which hopefully have discounted the worst case scenario, and I am short the market betting that the stock market is through discounting the best case scenario. Hopefully gold will hold either side of 1400 and/or the stock market will begin its correction. We will see.

But I think we are at an important inflection point for monetary policy that will affect stocks, bonds, and commodities in the weeks and months to come.

Paul Nathan
Paulnathan.biz