The Federal Reserve finally announced yesterday that it will begin tapering its massive balance sheet from October at a snail's speed.

The central bank is going to trim the balance sheet by $10 billion-a-month for the first three months, $20 billion-per-month for the next three, and on and on until it hits a pace of $50 billion per month.

During the press conference, Janet Yellen said that the balance sheet normalization would continue as the Fed would prefer to cut interest rates in case of an economic shock. The balance sheet expansion could be an option only if the interest rates hit the zero lower bound.

So, it is quite rational on the part of the Fed to signal one more rate hike this year and three rate hikes next year. The further the interest rates are from the zero lower bound, the bigger will the room be for balance sheet normalization.

To cut the long story short, the Fed just wants to undo everything that has not worked: unconventional policies.

Gold likes balance sheet expansion... only if it results in economic inflation

The chart above shows:

  • Unprecedented balance sheet expansion in the post-GFC period was accompanied by a spike in Gold prices to record highs above $1900 levels. Keynesians were running wild, calling hyperinflation due, although nothing of that sort happened
  • The bullish move ran out of steam as Keynesians were proved wrong - massive balance sheet expansion did not lead to hyperinflation in the economy, but only ended up inflating the asset prices [asset price inflation]
  • The Fed taper - realization that balance sheet expansion has ended - in 2013 also added to the bearish pressure around Gold.

If balance sheet expansion led to asset price inflation [bearish for gold], balance sheet taper could lead to asset price deflation [positive for gold].

Also worth noting - Asset price deflation usually leads to economic deflation as well. History shows Gold's purchasing power goes up during deflationary periods.

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