In the Face of Inflation, Gold's Luster Still Shines

It's getting kind of uncomfortable being a gold bug. I've been pushing gold as my “best idea” investment for many months. And I'm thrilled that it has been, by far, the best-performing risky asset throughout this whole horrible year of crisis.

But when it approached all-time highs in mid-February just above $1,000 per ounce, gold’s run petered out. It's been in a deep retrenchment ever since, falling as much as 13% from the highs two months ago. And some pretty powerful people are out there making persuasive arguments that my bull case for gold is downright wrong.

In a nutshell, my case is that gold is first and foremost an inflation indicator. I believe that the only way out of the current global inflation is for the Federal Reserve and the world's other central banks to create lots of inflation—to help governments finance the huge deficits they're taking on, and by keeping interest rates ultra-low in order to stimulate credit activity.

My evidence is the astronomically large balance sheet of the Federal Reserve. As I've pointed out here, the Fed's assets have nearly tripled since the middle of last year. As of the latest weekly report, they total almost $2.5 trillion, and the Fed has undertaken several new programs to buy even more assets.

But over the last three weeks, every time a senior Fed official has opened his mouth in public, it's been to contradict me. Chairman Ben Bernanke has done it twice (here and here). Vice Chairman Donald Kohn has done it three times (here, here and here). Even William Dudley, the president of the New York Fed who just replaced Tim Geithner after his move to Treasury, has weighed in (here).

They all say the same thing, over and over, in pretty much the same words. They say that they are very aware of the criticism (from people like me) that the Fed's gigantic balance sheet will lead to high inflation in the coming years. They say that most of the assets on the balance sheet are temporary, and that they will naturally roll off when the credit crisis eases. And they say that of the long-term assets, the Fed has the power to sell them anytime it wants.

On the one hand, it's very comforting to me that these powerful people are aware of the issue that others and I have been raising. It's great that they realize that they'll have to do something about it someday.

But on the other hand, there's something a little odd about three of the most powerful people in the world all saying the same thing, over and over. It they're so confident they have this problem nailed, why do they have to keep saying so? Maybe it's like Queen Gertrude said in Hamlet: "The lady doth protest too much, methinks."

Or maybe it's something else. These Fed spokespeople are so powerful, they know that the mere fact that they say something has a good chance of making it true. So maybe they think they can control inflation risk just by getting everybody to think there is none.

But there are powerful people who don't agree, also. Last week, when Kohn and Dudley protested too much at a monetary economics conference at Vanderbilt University, former Fed Chairman Paul Volcker stood up in the audience and called them on it. A particularly tense moment was when Volcker questioned Dudley on his claim that the Fed could control its balance sheet by manipulating the level of so-called excess reserves. Dudley had ended his speech making it sound easy, saying, “The challenge will be deciding on the best option, not in finding a workable approach.” Volcker said to the assembled crowd after hearing Dudley's non-explanation, “Now I'm more confused.”

Someone else who doesn't agree is Allan Meltzer, economics professor at Carnegie Mellon University. Now aged 81, Meltzer has studied the Fed his whole career, and written a magisterial two-volume history of the institution, and he knows all the players there. On Thursday he told me that he's “discussed this with some of them directly. I told them I haven’t the slightest doubt you have the technical capacity. What I doubt is that you have the political will.”