Dollar sinks and gold soars as Fed signals it wants to stoke inflation

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Investors and traders dumped the dollar and sent gold to yet another record high Tuesday, taking their cues from the Federal Reserve’s apparent readiness to drive interest rates down further and inflation up.

The markets’ verdict was clear: They believe Fed Chairman Ben S. Bernanke is willing to debase the dollar to avoid the risk of the economy falling into deflation.

The euro currency surged to a seven-week high of $1.326 from $1.306 on Monday. The DXY index, which measures the dollar’s value against six other major currencies, slid 1.2% to 80.40, its lowest level since mid-April.

Near-term gold futures, which fell $6.60 to $1,272.40 an ounce in the regular trading session, rocketed to a record $1,289.40 in electronic trading after Fed officials ended their September meeting. Gold now is up almost 18% year to date.

In their post-meeting statement, policymakers signaled that they’re worried that inflation has fallen too low, with the “core” consumer price index rising year-over-year at a rate of less than 1.0% in recent months, a 44-year low.

That means the economy has been skating closer to possible deflation, or falling prices -- every central banker’s nightmare because that trend can be difficult or impossible to reverse once it takes hold.
The Fed didn’t announce any change in policy Tuesday, but financial markets read a shift in the Fed’s statement on inflation as a sign that the central bank soon could launch a huge new round of “quantitative easing” -- meaning, a massive program of Treasury bond purchases, perhaps totaling upwards of $1 trillion.

The goal would be to pull longer-term interest rates lower, pump up the supply of money in the financial system and, the Fed would hope, eventually boost inflation.

But any move to flood the system with more dollars would be expected to drive down the greenback’s value. So would lower bond yields, by encouraging investors to look to other countries’ bonds for better returns.

Taking their cue from what they expect is coming from the Fed, investors and traders fled to other currencies Tuesday, sending the dollar broadly lower.

“The Fed is actively trying to make the dollar less and less attractive,” said Kathy Lien, a currency strategist at GFT Forex in New York. A weaker buck would help U.S. exporters by making their products less expensive abroad, but it also means Americans’ purchasing power would dwindle.

Gold, meanwhile, got a boost as the anti-dollar -- the alternative to paper currencies. What’s more, anyone who expects the Fed to succeed too well, unleashing sharply higher inflation in the next few years, naturally would be drawn to gold as a classic inflation hedge.

With the Fed “now explicitly committed to inflation, investing in gold and foreign currencies becomes an easy decision,” said Peter Schiff, head of Euro Pacific Capital and one of the central bank’s biggest critics.
The possibility of a new Fed program of Treasury purchases drove bond yields sharply lower. The 10-year T-note yield slid to 2.57% from 2.70% on Monday, the biggest one-day drop since June 4. The five-year T-note yield fell to a 21-month low of 1.30% from 1.41%.

But bond investors should recognize the risk here: If the Fed eventually gets consumer prices rising at a faster pace, locking in these yields could mean being stuck with securities earning less than the inflation rate.

-- Tom Petruno