Fed in panic lifts precious metals

Just when it seemed that disappointment over the still ongoing negotiations between Greece and the International Institute of Finance (IIF - an association of international banks) over the private sector involvement (meaning the voluntary hair-cut in a restructuring of Greek debt) would send gold prices lower again, the Federal Open Market Committee came to the rescue. After the release of the FOMC statement, gold rallied on a weaker US dollar and recovering stock markets. The announcement that it would be “… likely to warrant exceptionally low levels for the federal funds rate at least through late 2014” came as a surprise.

It appears as the Fed had acted in a panic mode. Compared with forecasts made in November, the Fed had reduced its central projection for GDP growth for the period 2012 – 2013, but increased the forecast for 2014. GDP growth in 2012 is now expected to be 2.2 – 2.7% and to increase to 3.3 – 4.0% in 2014. Inflation measured by the PCE deflator is expected to remain below 2% for core and headline inflation over the forecast horizon. While the Fed also lowered the projections for the unemployment rate, the decline is not fast enough from the perspective of the FOMC to reach the target level by mid-2013. Under these projections, it would be understandable if the Fed were keeping rates unchanged. However, communicating the projections and the implications for the Fed funds rate could have negative implications.

To some extent also due to the headlines in media, financial markets have understood the statement as a firm promise that the Fed funds rate would be held at the current level until late 2014. But forecasts are subject to revisions. If the assessment of the Fed turns out as being too pessimistic on GDP growth or as too optimistic on core inflation, then the Fed would have to tighten monetary policy before late 2014. This could damage the credibility of the Fed. But keeping the rates unchanged as promised and letting inflation rise above the target would also damage the credibility of the Fed. Thus, positive surprises for the economy could turn out as a problem for the credibility of the Fed. On the other hand, forecasts could become self-fulfilling. Signaling to keep the Fed funds rate unchanged for almost 3 more years might be interpreted by businessmen and –women as an indication that the economic recovery remains rather fragile. It could have a negative impact on expectations of future returns on investments and thus, lead to postponing business fixed investments further into the future. In this case, the announcement of keeping the Fed funds rate unchanged for such a long period could weaken instead of strengthening the economy.

In the FOMC statement, the Fed recognizes that “… growth in business fixed investment has slowed”. As a policy measure, the FOMC “…decided to continue its program to extend the average maturity of its holdings of securities…” Thus, operation twist is going to continue. We have some doubts that operation twist would lead to accelerating growth of business fixed investment. Empirical research showed that the steepness of the US Treasury curve is an important indicator for future US GDP growth. Certainly, we would not doubt that also the level of interest rates plays a role for business fixed investment. However, we are skeptical whether companies, which did not invest at yields on 10yr US T-notes at 2.0%, would invest at 1.5%. However, reducing the spread of corporate bonds or mortgage bonds over US Treasury paper might have a far bigger impact on business fixed and residential housing investment.

Fed chairman Bernanke pointed out that the debt crisis in the eurozone is one of the biggest risks for the US economy. We fully agree with this assessment. Probably, it already has a negative impact on US GDP growth. In many market comments on the US stock market, the debt crisis in the eurozone was a major factor weighing on sentiment and stock prices. The development of stock markets also plays a decisive role for business expectations and investment decisions. But, the Fed is not participating in solving the debt crisis in the eurozone. Due to legal reasons, the Fed can not provide funds to the IMF. However, the Fed could extend its balance sheet by acquiring foreign reserves – either by a swap agreement with the ECB or by interventions in foreign exchange markets. The later would also have the advantage of weakening the US dollar and stabilizing the euro. The increased foreign reserves could then be invested in government bonds of Italy, Spain and France. This would reduce the yields on bonds of these countries and would reduce the fears that these countries would have difficulties to place their bonds. As has been seen since the start of this year, easing tensions in the eurozone peripheral bond markets are positive for stock markets in Europe, but also in the US.

The Fed policy of keeping the Fed funds rate at record low levels until late 2014 has a positive impact on gold via a weaker US dollar. However, if the Fed would shift the focus of its policy from lowering yields on US Treasury notes and bonds towards strengthening the US stock market and thus, sending positive signals to US companies, but also consumers, then the precious metals probably would get an even stronger positive impulse.