Will Fed Finagling Send Gold Skyrocketing Again?

Investors don't expect the Fed to raise interest rates for a while. According to CNNMoney, the spread on a 10-year interest rate swap, reflecting how much an issuer of floating-rate bonds would pay to fix the interest rate on those bonds, turned negative this week for the first time. This is great news for gold bugs, who love nothing more than a chance to chatter about the Fed's out-of-control money printing.

But this prolonged low-interest theory is at odds with the opinions of analysts at Moody's (MCO), which threatened to downgrade its U.S. debt ratings last week. The credit rating agency is worried that the rate the government pays to borrow money for five years will "nearly double between now and 2012," according to CNNMoney, and that higher interest expense could crowd out other, more productive, ways to spend government money.

These contradictory perspectives suggest that investors are caught in the horns of a dilemma. So it's worth noting that for its part, the Fed has been threatening to raise interest rates if it sees signs of inflation. It already raised the Discount Rate, which has had little economic effect, but signals the beginning of an elaborate and well-promoted plan by the Fed to drain excess liquidity from the credit markets as the economy recovers in order to tamp down inflationary pressures.

Counting on Uncontrolled Inflation

But revolutionary fervor fuels the gold cult: True believers in the precious metal are convinced that the Fed is violating the Constitution by even existing. The rhetoric from the gold camp is based on two ideas:

  • A global financial catastrophe is imminent; and

  • Owning gold is the only way to protect yourself.

Here's an example of this lunatic raving from the blogger goldmap: "We're closing in on the time when, like a light bulb turning on, Americans will finally realize that they've been hoodwinked by one of the greatest swindles in the history of civilized man. They've been working and saving printed paper with the firm conviction that the paper they worked so hard for was money. Wait, why is that printed paper worth anything at all?"

The basic premise of the gold investor is that inflation will skyrocket, turning currency into worthless paper and making gold the only store of value. The key flaw in this argument is that, like planning for Armageddon, it only works when a date is set for the end of the world, and then the world keeps on going after that date.

As long as the disaster is just out of reach, investing in gold makes sense. The reality is that there is no significant inflation now. Consumer inflation excluding food and energy was just 1.3% for the 12-month period that ended in February. And that number was even lower for the previous six months. If at some point, the Fed perceives a danger of inflation, it will raise interest rates to squash it.

Hence, the gold investor's quandary: There is no inflation now, the danger of future inflation is the only thing that keeps fanning the flames for their favorite asset, and the Fed is sure to raise rates before inflation gets baked into investors' expectations. Therefore, it is essential for gold bugs to present the Fed as essentially powerless to stop the inflationary monster it has created.

If the Federal Reserve starts raising rates, the rest of us should celebrate, because that will mean the Fed thinks the economy is really recovering -- but gold investors will moan if it does, because higher interest rates would cut into the value of their shiny metal.