History is Important: 2003 All Over Again?

In the most recent Federal Reserve Open Market Committee meeting statement from September 21, 2010 the Committee stated that, “Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.(FRB Press release).  Think about that paragraph.  The Federal Reserve is worried and thinks inflation needs to increase for maximum employment.  If they are willing to state that they want inflation higher than it is not too far a leap to think that there are some discussions about the possibility of deflation.  This is where history comes in.

The last time the FOMC acknowledged the possibility of deflation was in their March 18 2003 statement.  The statement was much more subtle and obfuscated consistent with the Chairman at the time, Alan Greenspan, and comes in the third paragraph, “In light of the unusually large uncertainties clouding the geopolitical situation in the short run and their apparent effects on economic decision making, the Committee does not believe it can usefully characterize the current balance of risks with respect to the prospects for its long-run goals of price stability and sustainable economic growth. Rather, the Committee decided to refrain from making that determination until some of those uncertainties abate. In the current circumstances, heightened surveillance is particularly informative.” At that point interest rates were also very low with Fed Funds at 1.25%. Let’s look at charts of the US Dollar Index, Gold, Crude and The S&P500 Index from that time period.

Gold Continuous Contract 2002 – 2004

US Dollar Index 2002 – 2004

West Texas Intermediate Crude Continuous Contract 2002 – 2004

SPX 2002 – 2004

These charts show that prior to this revelation by the Fed that Gold and Crude had already been rising for sometime. Also the US Dollar Index had already been falling for a year since its top in February 2002.  With interest rates at a very low level the only tool available for the Fed was to devalue the US Dollar.  So how did the statement impact these markets?  The clearest reaction is seen in the S&P 500 Index, which rifled off of the bottom to rise 38% over the next 9 months.  Oil stabilized.  Gold continued its rise.

Why is this important?  With the shift in Fed speak on inflation last week, when interest rates are at zero, this also leaves the Fed with only one tool, a devaluation of the currency.  Expect that as they use it the current trend in Gold will continue and that the S&P 500 will join it. There may be a pullback here but devaluation will lead markets higher.

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