To QE or Not to QE, Disinflation May Be In the Cards

In its most recent Meeting Minutes for June 19-20, which were released on July 11th, the FOMC gave no indications of another round of stimulus or QEIII. Nevertheless, the monetary policy making committee did reiterate that it would continue its “Operation Twist” program of bond repurchases through the end of this year.

While the immediate reaction to the FOMC Meeting Minutes depressed precious metals prices and drove the U.S. dollar higher, markets corrected afterwards. The price of gold dropped marginally, and the price of silver actually rose by 10 cents per ounce.

The Fed’s monetary policy has exerted considerable influence in all capital markets and will continue to be a driving force in the perceived value of the U.S. dollar that is ultimately reflected in the pricing of consumer goods.

Disinflation and its Possible Benefits

Disinflation is typically defined as a drop in the rate of inflation or a decrease in the general level of the prices of goods and services in an economy over a period of time. Disinflation’s opposite is reflation, where the rate of the increase in the prices of goods and services accelerates.

Disinflation only occurs during recessionary periods and generally when the level of inflation is not very high to begin with. The lower cost of goods and services in a recessionary economic environment could provide some benefits.

Globally, the economies of Europe and China have been slowing down, which directly affect the prices of goods in the United States. In his most recent press conference following the last FOMC meeting, Fed Chairman Ben Bernanke stated that,

“I do think that the European situation is slowing U.S. economic growth. First of all, Europe is, if not in a recession in every country, certainly many countries are in recession, and that affects our trade with Europe and the demand for our products. More broadly, the effects of European concerns on financial markets have added to volatility, have brought down stock prices, have increased credit spreads, and generally have been a negative for economic growth.”

He continued by saying that,

“So that has been an issue. And more broadly, we’ve seen some slowing in global economic growth more generally, including in Asia, which also has reduced somewhat our ability to export.”

Operation Twist and the Fed’s Treasury Position

Due to the Fed’s Operation Twist debt repurchase program, the Fed’s debt holdings have been converted into mostly long-dated treasuries. At some point, the Fed will have to deleverage their position, since they most likely do not wish to continue buying U.S. debt in perpetuity.

When they eventually do begin to unwind their position, they will have to sell long-dated treasuries, thereby putting upward pressure on long term yields. As those yields begin to increase, the rising differential between near and long term rates would cause the yield curve to steepen.

With a wider differential between short and long term interest rates, demand for capital would increase, and this should consequently benefit precious metals prices. Silver prices would rise considerably as growing demand for products would increase the demand for silver in industrial applications.

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