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david rosenberg

The media and the markets are analyzing every word that Ben Bernanke utters in an attempt to predict his plans for another round of financial stimulus. But what may be more important for investors is what the U.S. Federal Reserve chairman isn't saying.

In a speech last week, Mr. Bernanke hinted strongly that he would be open to approving a second round of so-called quantitative easing at the Fed's next meeting on Nov. 2. But in the course of his 4,000-word speech, he made no mention of the inevitable impact of quantitative easing on the U.S. dollar. It's that impact that should be guiding investors' decisions.

Quantitative easing, or QE, is a policy in which the government creates money out of thin air to buy bonds, thereby driving up the price of those securities and driving down interest rates, which move in the opposite direction to bond prices. It's an unorthodox measure and one undertaken only in unusual times, like the present, when policy makers are concerned about the risk of the economy falling into a debilitating round of deflation, which could hammer stock prices and real estate values and lead to yet more economic distress.

Policy makers have every reason to be worried about deflation. Core inflation in the United States is now at a 49-year low. The most recent consumer price index showed that prices are falling - or at least rising more slowly - for many goods and services. Restaurants, airlines and hotels are still putting through price increases, but prices for apparel and autos are tumbling.

While retail sales were firm in September, all signs point to widespread discounting. J.C. Penney, for example, reported that average unit retail prices were down last month amid a "competitive promotional environment." Abercrombie & Fitch said total sales rose 25 per cent but at the expense of deflating average prices by 12 per cent - remarkable. Wal-Mart stated that "the holiday season will have a strong - a very, very strong - price focus," adding that "we expect that retailers will be focused more on needs instead of wants." (Would you like that toothbrush wrapped?) But if retailers and policy makers are concerned about deflation, many investors seem worried about the opposite problem. They fear that the Fed's attempts to stimulate the economy will eventually lead to an outburst of inflation. This is one reason why gold has broken out so violently. Investors are seeking a hedge against the long-run risk that the U.S. dollar will be devalued.

The Fed, to be sure, doesn't want to create consumer inflation with a new round of QE. Instead, by driving down interest rates, it wants to drive up the relative value of assets such as stocks and housing.

If the Fed succeeds, companies will have new incentive to invest in plant and equipment rather than stockpiling cash. To add those new plants and equipment, companies will have to hire workers and stepped-up job creation will result. Meanwhile, households will feel wealthier because of higher home values and stock prices, and may start spending more. That, too, could help boost the economy.

The Problem

The problem, of course, is that artificially raising asset values could perpetuate the boom-bubble-bust cycle that has come to dominate the past 12 years. Having central banks attempt to determine asset values and push them above their intrinsic levels provides buying opportunities in the short term. Unfortunately, as we've seen in recent years, these cycles of blowing bubbles never end well.

The challenge for the Fed is that the post-bubble U.S. economy is caught in a classic liquidity trap, in which short-term interest rates can go no lower because they're already bumping up against zero. At the same time, additional fiscal stimulus is no longer a viable political option when deficits are already running at record levels. That leaves unorthodox monetary stimulus by the Fed as the only game in town. Mr. Bernanke knows there is a chance that another round of QE will be met with only limited success, but he has few other options.

One thing that does seem certain is that the Fed's actions will have global consequences, as the money the central bank prints to buy bonds will inevitably trigger more depreciation of the dollar against other currencies. But in his speech last week, Mr. Bernanke made no mention at all of the slip-sliding U.S. dollar.

Don't be fooled. Part of this new round of QE will involve a depreciating greenback - a trend already under way. This is where Mr. Bernanke's silence is golden. Precious metals would seem to be the best hedge against the falling U.S. dollar. Another good hedge is Canadian bonds, which will trade in lockstep with U.S. Treasuries, but are denominated in a currency that isn't about to become debased.