THE BLOG
01/25/2011 01:12 pm ET Updated May 25, 2011

Bernanke's Golden Dismount

Investors in the Golden metal have enjoyed significant profits so far during the tenure of Benjamin Bernanke. However, some now fear that the recent selloff in gold presages Bernanke's imminent dismount from his monetary high-wire act. But that fear is completely unjustified given Bernanke's economic philosophy and the Fed's own recent history in raising interest rates.

First off, the current head of the Federal Reserve concentrates on three key pieces of economic data; the unemployment rate, core inflation and home prices in order to determine his stance on monetary policy. Ben tends to overlook the regional manufacturing surveys, which have rebounded significantly in some cases, and also glances past overall inflation metrics, which are rising at a faster rate. The unemployment rate is 9.4%, YOY core CPI inflation is up just .8% and the Case/Shiller Home Price Index is down .8% from the year ago period. Therefore, in context of Bernanke's knowledge of The Great Depression, any future increase in interest rates will be moderate and gradual in nature and the start of any such liquidity withdrawal will be held in abeyance for a very long time.

However, despite the fact that some economic data is improving, the foundation of the economy is getting worse. Consumers are now increasing their borrowing again -- as evidenced by last week's number on consumer credit -- and our government is now massively over leveraged. But leaving alone the deteriorating nature of the economy, the Fed's own history with raising rates provided some unexpected good news for those who held tight to their gold positions. So let's take a look at the Fed's last round of rate hikes and see how they affected the price of gold.

The Fed began its last round of rate hikes in June of 2004. Then Fed Chairman Allen Greenspan began a sequence of 25 basis point increases that lasted until the baton was passed to Ben Bernanke in February of 2006. Bernanke increased interest rates three times by ¼ point and the combined effort on the part of Greenspan and Bernanke took rates from 1% to 5.25% in the span of two years.

As you can see, since the era of 100% fiat money began in 1971, a Fed Funds rate of 5.25% is historically quite low.

Since the Fed increased interest rates very slowly from an extremely low level, money supply continued to expand and the dollar price of gold increased. From June 2004 thru June 2006 the M2 money supply increased 9.3%, rising from $6.27 trillion to $6.85 trillion. Total Loans and Leases from commercial banks jumped from $4.61 trillion to $5.71 trillion during that same time period, which was an increase of 24%! The price of gold increased from $395 to $623 per ounce during the dynamic Fed duo waged their phony war against the asset bubbles of the mid 2000's.

The truth is that bank lending practices aren't curtailed very much by a Fed Funds target rate that is increased very slowly from a starting point of just 1%. That is the reason why the price of gold increased by 60% during the Fed's last "battle" with inflation. Therefore, investors can safely assume what will happen when Bernanke eventually begins to lift the target rate on overnight bank lending from zero percent. In addition, investors should keep in mind the asset bubbles that were generated by keeping rates near 1.25% from November of 2002 thru August of 2004. Now however, the Fed has kept interest rates near zero percent from December 2008. Why should we expect a different outcome this time around?

A key point to mention here is that the credit crisis and collapse of the housing market was not engendered by a Fed Funds rate of 5.25%. Rather it was the case that real estate prices simply went too high and became unaffordable to most consumers. Banks then became insolvent because their assets were crumbling. After their capital became significantly eroded they were subsequently unable to lend.

Investors should take solace in the fact that Bernanke's dismount from massive money printing and rock bottom interest rates will be golden not because he will "stick" the landing but because owners of gold should continue to shine.

Michael Pento is the Senior Economist for Euro Pacific Capital.