As the Fed gets ready to tighten, it may be time for gold bugs to sell

Ben Bernanke has been signaling that he's getting ready to tighten the money supply. And for a student of the Great Depression like Bernanke, those warnings have particular resonance. That's because one of the criticisms of the Fed during that time was that it tightened too early.

So the Fed chaiman's statement last night implying that the central bank could raise rates in the second half of 2010 reinforced earlier Fed pronouncements about removing $1 trillion in cash from the financial system. And not coincidentally, the price of gold fell from its recent high of $1,060 down to $1,050. Is it time for gold bugs to lighten up?

Since high school, I have wondered what compels people to attach value to a fairly useless, but admittedly shiny piece of metal. Last fall I attended my wife's Harvard Business School (HBS) reunion where I chatted with a fellow who lived in a wealthy Boston suburb who told me he had his money in gold bars locked in a safe in his basement and an arsenal of guns to protect it. This incident highlights to me how seemingly intelligent people can be seized by a sort of brain fever that warps their thinking when it comes to the topic of gold.

The Fed's warnings about tighter money could upset the apple cart that's been driving markets over the last several years of loose money that got started around 2001. For years, global corporations have savored the loose money because it led to a lower dollar, which made their goods cheap overseas. The weak dollar also boosted commodities like oil and gold that are traded in dollars.

But as I posted last week, gold does not go in only one direction. And it's a lousy inflation hedge because if you had purchased gold at its inflation-adjusted peak of $2,000 an ounce in 1980 you would now be sitting on a 50 percent loss. Obviously, if you look back in history, you can find times when gold went up -- and you can construct a hypothetical trade that will make you money.

But the point is that gold can go down. And that decline tends to happen when the Fed gets serious about reducing the money supply. So if the Fed goes ahead with tightening actions such as its $1 trillion reverse repurchase plan -- where it sells repos to its primarily dealers in exchange for cash -- and raises interest rates, the dollar will strengthen and commodities like oil and gold will drop.

I hate to think what that HBS alum will do with his gold and guns when the gold stash in his basement starts tumbling in value.

Peter Cohan is amanagement consultant, Babson professor and author of eight books including, You Can't Order Change. Follow him on Twitter.

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