When the Fed prints money it makes the price of gold go higher, and it makes the stock market go higher. Many Fed watchers had expected the US central bank to announce a new round of paper money creation, the third round of Quantitative Easing, or QE 3, at its FOMC meeting on August 1st. But it didn’t. In the following paragraphs, I will share my views on why it didn’t. I will also discuss the four developments that would force the Fed to push the print button. This is important because the chances are relatively high that the price of gold, the stock market and the economy in general will weaken until the Fed prints again (unless the European Central Bank, the ECB, jumps in with another big round of Euro printing, which certainly cannot be ruled out).
The economy is weak and getting weaker. US GDP grew by only 1.5% in the second quarter. Unemployment is high and getting higher, 8.2%. So why didn’t the Fed launch QE 3 this week to rev up the economy? I think there are two main reasons. The first is that printing money does more than push up the price of gold and stocks; it also pushes up the price of food. During the second round of QE, global food prices rose 60%, causing a humanitarian disaster for the two billion people on earth who live on less than $2 per day. After QE 2 ended in mid-2011, food prices gradually declined – until a severe drought struck the United States and drove corn prices back near record highs in recent months. That drought-provoked spike in the price of corn may have been the main reason the Fed did not act this week. They did not dare push global food prices higher still. The last thing they want is for the hunger-inspired Arab Spring revolutions to go global.
The second reason that held the Fed back this time could have been that interest rates are already too low. When the Fed prints money and buys bonds, it pushes up their price and that pushes down their yields, i.e. the amount of interest bond buyers receive. The yield on ten year US government bonds fell below 1.4% last month. They have never – I repeat NEVER – been lower. With the yield on government bonds so low, it will be very difficult for pension funds and insurance companies to earn enough money from their investments in bonds to pay their obligations to pensioners and policy holders. The Fed must fear that yields have already fallen to dangerously low levels. Therefore Chairman Bernanke and his colleagues are reluctant to print more money and cause bond yields to fall further still.
So, what would force the Fed to fire up the printing press? I believe there are four potential triggers that would force the Fed to print again.
The first would be a significant decline in the stock market. If stock prices began to plummet, (paper) wealth would be destroyed, consumer confidence would drop and consumer spending would fall. As a result, the economy would begin to contract and deflation would take hold. That is not a worry right now, however. The stock market is pretty strong. If the S&P Index dips below 1250 (from 1370 now), Fed action would become more likely. If the S&P begins to approach 1100, look for helicopter money to begin raining down from the sky.
The second trigger would be a spike in government bond yields. The US government must finance a very large budget deficit every year. The budget deficit has averaged about $1.3 trillion a year for the last four years. If the private sector won’t buy the government’s debt at low interest rates, the Fed would print money and buy the debt itself. Right now, as discussed above, that is not an issue either. Yields are very low. However, should the yield on ten year bonds rise above 3.5%, then it would become an issue and the Fed would consider printing.
A third factor that would push the Fed toward printing again is the threat of deflation – and this is once again becoming a real concern. With the US economy and the global economy weakening rapidly, the level of consumer price inflation (CPI) has started coming down fast. Now, however, the drought in the United States is likely to cause prices to rise again quite quickly, making near term Fed action less likely. It is certain the Fed is monitoring prices very closely because it is terrified of deflation. If rapid disinflation resumes, the Fed will print.
The final factor is the unemployment rate. If it moves up to 8.5%, the Fed will probably print more money. With the global economy weakening so quickly, that is a real possibility. If the Congress does not avert the “Fiscal Cliff” at the end of this year (when government spending is due to be capped and taxes are due to surge), it is an absolute certainty that unemployment will soar and the Fed will print.
So, in conclusion, keep an eye on the inflation rate and the unemployment rate. They are likely to determine when the Fed launches QE 3. And, until then be cautious. The price of stocks, gold and other commodities (not affected by the drought) are likely to fall – unless the ECB turns on its printing press and pushes them back up.
On a personal note, I spent the week of July 16th promoting my book, The New Depression, in London. The week began at 7:30 am Monday on CNBC Squawk Box Europe. Please find here the link to that interview: http://www.cnbc.com/id/48193471/How_Close_Are_We_to_New_Great_Depression