Gold has to be  one of the most misunderstood commodities around. It's adored and hated,  hoarded by governments and individuals, and shorted by institutions and traders.  It has been called money, a reserve asset, a predictor of fear, a gauge of  inflation, a gauge of deflation, a signal of impending crisis and more.

So what is it?

It used to be  money - but it's not now. Nowhere in the world is gold being used as a medium  of exchange. However it is being accumulated by central banks and held as  reserves; by individuals as a "store of value" and protection against  future crises and monetary upheavals; and by institutions as a diversified  investment vehicle. Gold has had a resurgence since the beginning of this  century - and with good reason.

In my book, (and  I do have a book), I view gold as having two distinct functions. The first is  as protection - a sort of insurance policy against the unknown crises of the  future - which could include economic, monetary, geo-political, or lately  technological breakdowns. In times of severe economic contractions, gold in  one's possession provides safety and liquidity. In times of financial panics,  gold remains safe and valuable in an unsafe world. In times of war, gold  provides security. And in times of technological breakdowns, gold remains in  your possession as an owned asset rather than a promised one.

Imagine if stock  exchanges closed due to hackers or terrorists, and banks and ATMs were unable  to provide you with cash. The only cash on hand would be the cash you have in  your wallet and your gold or silver coins (if you had them) which would be  readily acceptable for food, water, and gas from those that had surpluses. No  one wants war, nor monetary, economic, or technological breakdowns. But they  are possible - and lately more possible than ever. Gold provides some  protection against emergencies and crises, and always has. The price is higher  today than in the 80's and 90's, because the risks of monetary, financial, and  economic upheavals are greater along with the threat of terrorists and hackers  always lurking, always planning.

Second, gold  provides a very vital function as a barometer of fear and crises, and as a  gauge of future inflation and deflation. Gold rises during fear of war, and it  rises if individuals begin to mistrust their money and the government's  handling of their money and finances. Things like fear of growing deficits,  debt, and possible default all show up as an increase in the price of gold.  Similarly, fears of inflation and devaluation show up in a higher gold price. A  falling gold price often indicates disinflation or deflationary trends at work  and possible recession or depression ahead. Or it could be simply indicating a  return to normalcy after a traumatic period.

The predictive  power of gold is not to be ignored. Two years ago the price of gold began to  fall. One message gold was forecasting was a reduction in the rate of inflation  and the rate of growth. At the time, most estimates were for inflation and  growth to rise to somewhere between two and four percent. Many were predicting  runaway inflation. Instead we find ourselves today at .06% inflation according  to the PCE and a pathetic average growth rate of about 2%. Gold has recently  stopped falling and has leveled off in a range of about $1270 to $1435 an  ounce.

What is it  signaling now?

Gold was falling  hard as the Fed indicated they were going to tighten. It was a signal that the  Fed was too tight and risked deflation ahead. James Bullard of the Fed changed  the signal to the market when he dissented, citing the falling inflation rate  as a worry. He reignited fears of the threat of outright deflation, and many on  the board including Bernanke listened. Gold stopped falling and rallied as  others on the Fed made it known they too were concerned about the falling  inflation rate and the slow pace of growth.

The money supply  as measured by the non-seasonally adjusted M2 figures shows the rate of change  of money falling since the beginning of the year along with the inflation rate.  Money is just not getting into the hands of the public. The CRB commodity index  reflects this tight money condition by falling, indicating a disinflationary  bias at work. "Quantitative Easing" is not doing what it was intended  to do.

If the Fed is to  achieve its goal of a 2% inflation rate they will need to change tactics. Bond  buying is doing little to increase money in circulation. Banks need to loan  more to increase the "velocity" of money. Without more money chasing  goods, you cannot have true quantitative easing. I'm a hard money kind of guy,  but a 2% inflation tax would be preferable to me than a Japanese-style  deflationary recession. The reason to set a target of 2% inflation is to create  a buffer between inflation and fears of deflation that can become  self-fulfilling. Gold was signaling that was the direction we were headed. We  are still in a world of deleveraging and the bias is toward disinflation and  deflation.

But with the  recent decision of the Fed not to tighten, gold has stabilized. I personally  believe more is needed from the Fed. One such possibility is for the Fed to  lower the interest rate they pay banks to hold reserves. Over two trillion  dollars of the money the Fed has created is sitting dormant as reserves. Lower  the rate of interest to the point it will entice banks to lend, and the  quantity and velocity of money will grow. That will help relieve the  deflationary/recessionary bias in the economy. It will also allow the Fed to  reduce its bond buying program in a non-deflationary way.

I believe the Fed  must replace QE from bond buying, which has not been effective, to another  method of increasing money in circulation. Lowering the interest rate on bank  reserves is one alternative way toward mobilizing the existing stock of money.

If the inflation  rate becomes a problem, the Fed knows how to deal with it. They can reduce the  money supply as fast as they created it. They can raise interest rates on bank  reserves, or sell paper to the banks thereby contracting loanable reserves. We  have a lot more experience with fighting inflation successfully than we do with  fighting deflation.

I have said in  many past articles that the only thing the Fed can do efficiently is control  the rate of inflation. They can't control employment or growth rates, or even  interest rates on the long end. They should stick to what they can do, and  right now that is preventing deflation from taking hold.

Watch gold. If it  breaks lower it is signaling a deflationary recession ahead. If it breaks  higher it is signaling higher inflation and most likely higher interest rates.  Employment and growth rates are more a function of fiscal policy, regulation,  and general business conditions, than monetary policy. The best thing the Fed  can do at present is to watch gold and commodities as a gauge of monetary  tightness or looseness and to act accordingly.

Paul Nathan
Paulnathan.biz