Gold Bugs Should Take the Fed's Discount Rate Hike As a Warning

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On Thursday afternoon, the Fed raised its discount rate -- the rate it charges to banks for direct loans. As I wrote in October, the Fed has been broadcasting its intention to tighten the money supply since the fall. Yet despite all that advance warning, Friday morning's strengthening of the dollar and the subsequent fall in commodities -- which trade in the now-stronger dollar -- suggest that investors were surprised. The Fed's next moves will be especially painful for one class of investor, in particular: gold bugs.Before getting into this, let's take a look at what actually happened Thursday afternoon. For the first time since June 2006, the Fed raised the discount rate by a quarter-point to 0.75%. Its near-zero fed funds rate -- to which consumer lending rates are tied -- remains at rock bottom and has not changed. But this move speaks more eloquently than words that the Fed believes that the financial crisis is over and an economic recovery is beginning.

But the 75-basis-point discount rate will narrow the spread for banks' easy money. According to The New York Times, the spread between short- and longer-term government interest rates had been a relatively wide 2.9 percentage points. Banks could borrow money from the Fed at 0.5% and invest it virtually risk free in longer-term bonds. Thursday's move signals that the easy money for banks is coming to an end as the short-term rates begin to rise and those spreads narrow.

The Fed's elaborate signaling ritual is probably the beginning of a series of moves reflecting its conclusion that the balance of risk has shifted from deflation to inflation. The Fed will likely make other moves such as boosting the Fed Funds rate, which actually affects consumer lending rates, and selling off the additional $1.4 trillion in Wall Street junk that it loaded onto its balance sheet -- which formerly stayed level at $800 billion -- to save the financial system in 2008.

There's More to the Fed Than Keeping Interest Rates Low

Such moves -- which are among the eight signs that the recession is over -- would be cause for concern to gold investors. Some of these gold holders have locked themselves into a powerful mindset which is very difficult to get away from -- it's almost like a gold cult. A few years ago, I met a Harvard Business School graduate who had all his money in gold bars locked in safes in his basement that he surrounded with an arsenal of guns.

Folks like him find inspiration in the gold-sponsored Glenn "Passion For Gold" Beck, who thrives on fear of the Fed and its printing presses. Their basic idea is that the Fed is part of a global banking conspiracy that will use its control of the money supply to print huge quantities of useless paper and then throw everyone in concentration camps as Armageddon approaches. It's a compelling paranoid fantasy for some.

But what these folks forget is that the Fed does other things besides cut interest rates and keep them low. It also fights inflation -- hopefully before it becomes too deeply embedded in investors' expectations. And Thursday's move means that the Fed is becoming more afraid of inflation than deflation. As I wrote a few days ago, this shift in policy is going to create winners and losers -- particularly if the U.S. gets serious about reducing its debt and cutting its budget deficits.

Among those losers could be the gold bugs.

It's time to sell gold before the Fed raises its fed funds rate -- a move that should not surprise investors when it happens.
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