Hold Your Nose and Go with the Fed

11/15/2010 11:11 am EST

Focus: MARKETS

Axel Merk

President and Chief Investment Officer, Merk Investments, LLC

Axel Merk, president and chief investment officer of Merk Investments, urges investors not to fight the Fed in its misguided money printing.    

The Federal Reserve’s strategy of firing up its printing press may have the debasement of the US dollar as its goal, but it’s important to note that the Fed does not act in a vacuum. In our humble opinion, Fed Chairman Bernanke is wrong both on substance and politics--a potentially explosive mix.

On substance, the Fed recently stated in the Federal Open Market Committee (FOMC) minutes that businesses were holding back investments because of fiscal and regulatory uncertainties. In the FOMC’s own analysis, the economic recovery should strengthen in 2011, even without additional stimulus.

Additionally, commonly followed metrics used to measure the market’s inflation expectations are, and have been, approximately 2%. Even if inflation expectations were to drop lower, Thomas Hoenig, the lone dissenting voice on the Fed, rightfully argues a little deflation may not be any worse than a little inflation. In our view, printing upwards of $600 billion in fresh money may be the wrong prescription for the current situation.

A key impediment to the US economy is that policy makers are fighting market forces. Consumers would like to deleverage further; however, deleveraging may imply lower home prices [and] more foreclosures and bankruptcies.

While such dynamics are sorely needed for a more sustainable recovery, promoting what may be the healthiest economically may be political suicide. Consumers [who] downsize may actually live in a house they can afford; such consumers will once again have disposable income, be able to save, and possibly be able to afford a bigger home down the road.

If, in contrast, a consumer is subsidized to stay in a home he or she cannot afford, that consumer will continue to be a slave to their mortgage, [without having] money to pay for unexpected repairs, such as a new roof or disposable income to spur growth in the economy. Indeed, some argue that the economic boom that followed the Great Depression was a result of weak businesses failing.

When enough money is thrown at an ailing industry, it may be possible to prop it up. However, such efforts will likely require a lot more money than policy makers anticipate. It appears Bernanke has already come to this realization--purchasing $1.3 trillion in mortgage-backed securities (MBS) didn’t have the desired effect, hence QE2.

The real Achilles heel for policy makers is a lack of control over where the money printed actually flows. Both fiscal and monetary stimuli may not flow to where the money is needed, but to where the greatest monetary sensitivity is. Intuitively, commodities, precious metals, and currencies with a high correlation to commodities, such as the Australian or Canadian dollar, may benefit the most.

Read more commentary from Axel Merk at the Merk Mutual Funds Web site here…

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