When the U.S. Sneezes...

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Good Afternoon,

As trading resumed for the week, bullion prices slid sharply lower, first aiming towards the $915 level following a more than four dollar drop in crude oil to near $141.00 a barrel. A buying-induced recovery before futures closing brought the metal back very nicely to near $930 but those gains did not prove to be long-lasting. The US dollar first progressed towards 73.10 on the index, but later retreated to near 72.70 . This is shaping up as a busy week, complete with G-8 meeting results, as well as two appearances by Dr. Bernanke. Before we hear anything from Dr. B, we have already heard from his colleague, Janet Yellen who said today in a speech in San Diego that: " U.S. economic growth will ``pick up'' next year, and the central bank ``will not allow a wage-price spiral to develop.'' Guess we might know how that could be accomplished...

New York spot gold was trading on the downside at last check, quoted at $923.60 per ounce, off by $10 on the day, as the speculative focus shifted back to the oil market and dollar values and as the trade looked for additional new drivers in geopolitics and the US economy. Today's comeback could at least partially be attributed to the still visible undercurrent of credit worries out in the marketplace. Prices appear to be reasonably well bid in the mid $910's but resistance also looms overhead, at $936 as a first level. British and German drops in manufacturing indicate contagion from the US possibly spreading over to Euroland one year later, and could thus keep the euro in check for the second half.

"While the dollar may remain somewhat vulnerable against the euro in the near term, we continue to believe that the dollar is grossly under-valued and should perform better over the longer term against the majors,'' London-based Morgan Stanley currency strategist Stephen Jen said on Friday. ``It is the oil price issue that will likely cause the emerging- market dominos to topple over. Euroland will likely follow.'' Silver fell 48 cents to $17.78 while platinum lost $52 to break down to a one-month low of $1957 and palladium dropped $17 to $444 per ounce as apprehensions about the automotive sector's health and its effects on demand continue to swirl in the noble metals complex.

Apprehension of a related nature have also resurfaced in the gold market, as reports from India once again indicate that demand remains extremely price-sensitive. According to Bloomberg, " Gold imports by the world's biggest buyer of bullion, slumped 68 percent from a year earlier in June, as high prices eroded demand from jewelers and investors."

"Purchases declined to 24 metric tons from 74 tons, according to provisional data compiled by the Bombay Bullion Association Ltd., which represents 230 trading companies. Gold advanced 41 percent in the past year, touching a record $1,030.70 an ounce in March. The metal traded at $933.25 at close of trade yesterday. Prices for immediate delivery averaged $697.09 an ounce last year. India imported 722 tons of bullion in 2007, less than the 1,000 tons estimated by the World Gold Council at the beginning of the year."

***

Today's focus story is an interview granted by former St. Louis Fed President William Poole to the San Francisco Chronicle's Kathleen Pender. At the end of the day, the interview reveals quite a level-headed individual who shares more than a few concerns with some of his remaining Fed colleagues, as well as with economic scholars studying the current high-wire act being performed by the Fed. A few highlights of the recent Q & A follow:

Q: Are you still worried about inflation?

A: I am concerned that we have a very accommodative policy that will end up yielding an uncomfortable increase in inflation. I do not believe we are going back to the (hyperinflation of the) 1970s.

(Monetary) policy is very responsive to credit market turmoil. The credit market is directly related to the housing problem. That is going to continue unless we have an increase in the inflation rate.

Inflation shows up first in the prices of goods such as food and energy, which have long supply lags. That's exactly what we're seeing. We also have depreciation of the dollar, which is also consistent with leading-edge inflation.

Q: Should the Fed be doing more to fight inflation?

A: The Fed is in a very difficult situation. It would have been easier if rates hadn't been taken down to 2 percent (from 4.75 percent since September). I'd argue that we should reverse some of those cuts (perhaps 1.5 percentage points) on the grounds that those were emergency cuts to deal with credit market disturbances. With the credit market stabilizing, it's time to take that back.

Q: Will the Fed's next rate move be up or down?

A: It's very unlikely the next move will be to lower the rate (absent some surprise shock). My guess is the next move is up. When, I don't know. If we get worse-than-expected news on inflation and benign news on the economy, that might galvanize the Fed to raise rates. If inflation stays very modest, I don't see an increase until next year.

Q: We've got a lot of problems: a weak dollar, soaring oil prices, rising unemployment, housing is still a mess, financial institutions are crumbling. Which do you see as the biggest threat?

A: Some of these are related to the very accommodative monetary policy. It is partly responsible for the weakness of the dollar, which is (raising) import prices. It also has something to do with energy prices and the distress in airlines and automobiles. The economy needs time to adjust to higher relative energy prices.

In the house we are building, I think we are going to install a geothermal heating/cooling system. That's an extra capital cost but it will reduce energy use. That's the kind of capital cost households and companies can put in place, but savings in energy takes awhile to occur. We don't want the change in energy prices to lead to monetary policy that creates generalized inflation on top. That is where I fear we are headed.

Q: Are we on the verge of a global depression?

A: If you mean by depression anything like the 1930s, no. I don't think we are likely to have more than a mild recession.

Q: Do you see the Fed bailing out more banks or brokerages?

A: Bear Stearns was a real game changer. The Federal Reserve would find it very difficult not to engage in a similar operation with a large bank or another investment bank. The more interesting question is whether the Fed would step in for assistance on a large non-financial company.

This is an example, not a prediction: Suppose we have a further upward spike in energy prices and one of the top U.S. airlines says it has to discontinue operations. If this happens when Congress is out of session, the only possibility is Federal Reserve resources.

What argument is the Fed going to make when politicians come and say, "Look, you bailed out Bear Stearns." The airline has more employees than Bear Stearns and the collateral damage would be greater. Would the Federal Reserve say no under those circumstances? No one knows.

Until the Federal Reserve defines the rules of the game, who has access and who doesn't, anytime a corporate crisis occurs, people will be asking, Why isn't the Fed stepping in after all it did for Bear Stearns?

I'm a small boat sailor. If my boat is sinking, I'm going to bail like crazy to stay afloat. Once you have your situation stabilized, you better know what direction you're going or you are going to end up on the rocks. The Fed bailed like crazy, saved the financial system from a cascading collapse. What has not been done so far is worrying about the compass course.

Q: Should the Fed have done more to stop the housing bubble?

A: No, I don't think so. We all understood that the house price increases could not continue. We did not think through the possibility of a significant price decline and large-scale defaults and foreclosures.

The person who was closest to this was (the late Fed governor) Ned Gramlich. Ned was concerned about abusive lending and the risk to lower-income households. We understood there was abusive lending and practices that were stripping equity out of households. I don't remember the issue ever being raised that it could lead to defaults.

Q: If the Fed had acted to protect consumers, might it have prevented the credit crisis?

A: Maybe. The people who should have known were the financial firms sinking huge amounts of money into this. The biggest problems were mortgage originators who were not federally regulated. At this period there was a continuous push by Congress to make mortgage credit more readily available to subprime borrowers. For the Fed to have acted would have been contrary to the intent of Congress.

Q: Isn't the Fed supposed to be independent?

A: The Fed is independent up to a point. The financial community, the Fed, academics, didn't see the problem brewing."

Surely, Mr. Poole retains more than a few inside channels of communication to the Fed. Whether or not the central bank follows any of his advice remains to be seen. Late(er) in 2008 and early in 2009 the markets will give us a lot more facts than we can speculate about right now. In the interim, the show must go on.

Watch the action in oil, (and maybe in agriculturals) as the US and Japan have agreed late on Sunday (before the G-8 meeting) on the need to take "immediate action" against the stratospheric prices of oil and food. OPEC's president, meanwhile points the accusatory finger to ethanol as the culprit for the price of oil these days. The hunt for a prime oil market price explosion suspect continues. We'll stick with the hedgies, thank you. Details on how to address the oil price issue, were -of course- omitted from the US-Japanese resolve. Italian Prime Minister Silvio Berlusconi said today that deposits required to trade oil futures should be raised to discourage speculation, amid fears by ``some'' G-8 leaders that oil prices will reach $200 a barrel. An interesting footnote to all the recent energy cost stories: Israel plans to be combustion engine vehicle-free within 3 years' time. Talk about independence...

Tread with care, as gold might yet visit the $900-$910 value zone amid continued unsettled currency, oil and stock markets. The list of gain opportunities as well as dangers of losses (to the current gold price range) remains the same familiar one: oil, geopolitics, dollar policy, inflation, the global economy, and the (all too often) unpredictable one-off surprise event(s). Hopefully, not the kind Harry Schultz envisions in his latest TEOTWAWKI -flavored newsletter. But that's another story (you can find it on Marketwatch).

Happy Trading.