Recent financial news has been permeated
with talk of a new round of quantitative easing. Quantitative easing is a monetary policy used
by the U.S. Federal Reserve system’s Federal Open Market Committee (FOMC) where
the Fed expands its balance sheet by purchasing securities (usually from the
U.S. Treasury) on the open market.
During the 2008 financial crisis, the Fed performed two rounds of
quantitative easing, a policy that has received a mixed response from
economists.
The proposed new round of monetary
easing (QE3) comes on the heels of “Operation Twist,” a monetary tactic
designed to flatten the U.S. Treasury yield curve. Proponents of QE3 argue that the current
state of the economy is such that additional stimulus is required in order to
stave off an autumn decline in output. A
new round of securities purchases would be a defensive counter cyclical move by
the Fed.
Recently, Boston Federal Reserve
Bank President Eric Rosengren publically called for a sizeable QE3 in response
to disappointing output projections for the remainder of 2012. Although President Rosengren is a non-voting
member of the FOMC this year, his call for a third round of monetary stimulus
is demonstrative of the pro-stimulus wind of the committee. His comments during a CNBC interview on
Monday also included a call for lower interest rates on central bank deposits.
In a perfect world, quantitative
easing would inject needed liquidity into the economy, lowing interest rates,
and stimulating business investment.
This increase in investment would then raise total economic output. Consequently, unemployment would fall,
consumption would increase, and the economy would be put on the right
track.
The actual results of QE1 and QE2
are ambiguous. As anybody who has been
paying attention to the news over the last few years knows, unemployment is
high, consumption is unstable, and developed world output has been nearly
stagnant since 2007. Defenders of the
Fed’s action claim that had there been no quantitative easing, the global
recession would have been far worse.
Opponents point to the threat of inflation and the erosion of short term
lending due to nearly negative interest rates.
Regardless of the macroeconomic
effects of past quantitative easing, the prospect of a QE3 raises a number of
important points for investors. One of
the most talked about implications of QE3 is its effect on precious metal
prices. Precious metals appreciated in
response to monetary stimulus during the first two rounds of quantitative
easing. A Fed security purchase entails
the virtual creation of new currency and the expansion of the money
supply. This increased supply of money weakens
the dollar and causes metals to appreciate.
Precious metals thus can be considered a store of value. Investors are better off holding a real asset
than paper currency during inflation.
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| Red: Monetary Base Blue: Gold price per ounce |
Gold and silver have been
recognized as intrinsically valuable for millennia and investors know
this. If QE3 seems likely, investors
will buy gold ahead of time so that they can benefit from the
appreciation. This second force (anticipatory
purchases of gold) is the key to earning a return on a gold rally. Ideally, one would like to purchase gold at
the lowest price possible before both the anticipatory purchases begin in
earnest and the monetary expansion occurs.
If the price of gold increases, it will be largely because of market,
not monetary forces. Investors may want
to discuss the prospect of investing in gold or silver with their financial
advisor during what could be a new rally in precious metals.
Financial newspapers, talk shows,
and blogs are all discussing QE3. There
seems to be an incomprehensible volume of opinion and speculation, some good,
some bad, over Fed policy and investor sentiment. An experienced financial advisor can help his
or her client sift through the mass of opinion and determine what is the best
course of action given the potential for a rally in metals. In addition to discussing strategy, risks,
and potential returns, advisors can help clients better understand the variety
of metals based products, including gold and silver ETFs, physical metals,
bullion, certificates, and stocks.
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