For investors frazzled by the recent decline in gold and related shares, John Hathaway, portfolio manager for Tocqueville Asset Management, has some encouraging words. Chief among them: Don't fear the

Federal Reserve

, a particularly contrarian viewpoint these days.

"The correction is over," Hathaway declared Tuesday at the Denver Gold Group's San Francisco gold forum. "I see clear sailing -- new highs this year."

Hathaway, who manages about $700 million in gold-related assets, including the

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Tocqueville Gold fund, referred to a roughly 25% drop in gold shares since early December, as measured by the Amex Gold Bugs Index, and the yellow metal's apparent double top this spring at just under $430 per ounce. (Full disclosure: I am long Hathaway's fund, which is down 16.5% year to date but up 35.2% in the past three years and 25.2% in the past five.)

Ironically, his comments came on the same day

Alan Greenspan said the Fed is "prepared to do what is required" to restrain inflation, and prior to Wednesday's declines amid concerns about the potential for more aggressive Fed tightening.

Gold fell $6.60 to a three-week low of $385.20 per ounce Wednesday while the Gold Bugs Index tumbled 4.9%; industry bellwether

Newmont Mining

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fell 5%, while

Harmony Gold

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Freeport McMoran Copper & Gold

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Gold Fields

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were among the Big Board's biggest percentage losers.

The session further evinced how the yellow metal has become "co-opted by the reflation trade," Hathaway said Tuesday, presciently citing a near-term concern.

The 'reflation trade' refers to a notion -- which dominated Wall Street in late 2002 and much of 2003 -- that the Fed, fearing deflationary pressures, would maintain a highly accommodative monetary policy. The so-called carry trade -- in which money is borrowed at low short-term rates and invested at higher long-term rates -- was the practical means by which 'reflation' bets were made. As a classic inflation hedge, gold benefited greatly from the Fed's efforts to actually spur some inflation, rising from under $300 per ounce in early 2002 to nearly $430 this spring. Another result was the historically anomalous circumstance in which gold

traded in tandem with equities (and other financial assets) in much of 2003.

Not coincidentally, equities (particularly higher beta names), gold and speculative assets such as high-yield bonds have struggled this year as the Fed has gradually changed its public stance from concern about deflation to worry about inflationary pressures. If the Fed is going to actively combat inflation, rather than try to foster it, gold (and financial assets) become less attractive.

But the often

painful unwinding of such leveraged bets gives the Fed too much credit, according to Hathaway, who views the central bank as feckless to aggressively combat inflation and dishonest about its intentions to do so.

"Now that inflation is knocking on the door, the Fed has been forced to blow the whistle," Hathaway opined in a

report accompanying his presentation. "However, it cannot go beyond issuing warnings without sabotaging investors and borrowers alike."

Furthermore, "the only way to deal with entitlements

such as Social Security and Medicare is to devalue those claims in real terms" via a weaker dollar, he said, declaring the Fed's rhetoric about defending the dollar an empty promise. The greenback's recent advance, which accelerated Wednesday, is a "countertrend rally" in a long-term bear market, according to the fund manager.

Faulty Measures, Faulty Policy

Two key issues regarding Fed policy underlie Hathaway's long-term bullish view of gold. One, the real fed funds rate, or the fed funds rate adjusted for inflation, is negative and is likely to remain so. Two, official government measures understate inflationary pressures.

Regarding the former, he cited the so-called Taylor Rule, which aims to determine a "neutral" fed funds rate based on actual and potential GDP and inflation. Named for Treasury Undersecretary John Taylor, a former Stanford professor, the rule currently dictates that a neutral fed funds rate is about 4%, or 300 basis points above the current nominal rate. Since Sept. 11, the fed funds rate has been below its neutral rate "to a degree and length never seen during the Greenspan chairmanship," according to Bianco Research in Chicago.

Source: Bianco Research

Conventional wisdom holds the Fed will now move to narrow this gap. Indeed, conventional wisdom suggests the rally by gold (and other commodities) has come to an end as the Fed moves to forestall inflation. Analysts such as Jim Bianco and Martin Pring have made bearish calls on gold recently.

But Hathaway foresees the Fed remaining behind the inflation curve, unable (and unwilling) to tighten fast enough to match the rise in actual inflation, similar to what occurred in the 1970s.

"A core deception of the moment is the notion that a few upticks of 25 to 50 basis points in short-term rates will be sufficient to arrest the forces of inflation set in motion by the most aggressively accommodative Federal Reserve in history," Hathaway argued.

With the budget deficit, the war on terrorism, generous entitlement programs, high levels of adjustable-rate mortgages in the sub-prime market, unprecedented carry-trade leverage, and the stock market 'wealth effect' a cornerstone of policy, "a political Fed seems likely to opt in favor of glossing over substantive issues vs.

Paul Volcker-style tough love," he wrote. "The Fed may continue to bark but it cannot bite."

Regarding the latter, he cited the following:

On an annualized basis through 2003's third quarter, the consumer price index's housing component -- the largest single contributor to the overall index -- was up just over 2% vs. nearly 8% for the Office of Federal Housing Enterprise Oversight's (or OFHEO) own housing price index.

Why has CPI housing lagged amid the widely observed housing boom? CPI measures owners' "rental equivalent," or the amount homeowners think they can rent their house for, Hathaway observed. But because of generational low mortgage rates, home ownership is at record levels and rental markets are soft, diminishing "rental equivalents." OFHEO, meanwhile, measures occupancy costs, a more real-world measure of housing costs.

The CPI, he said, is further warped by so-called hedonic adjustments, which attempt to quantify the quality improvements in various goods. For example, average new car prices have risen by 308% since 1979 in actual dollars, but only by 71% according to the hedonically adjusted CPI.

If durable goods, for which the bulk of such adjustments occur, are excluded from the CPI, the inflation rate rises as much as 30%, Hathaway said. (On a separate but related note, the Cleveland Fed's median CPI was up 4.1% on an annualized basis through April vs. 3.3% annualize rate for core CPI.)

Finally, he noted the government data show capacity utilization at 76.9% through April but the Institute for Supply Management puts it above 80%. Again, the difference stems from the government's less-straightforward approach to measuring the data.

Fed policy is "based on faulty measures" that inevitably "lead to policy errors," including a fundamental understating of inflationary pressures, Hathaway said, explaining the core reason he remains long-term bullish about gold despite its recent struggles.

Aaron L. Task is the assistant managing editor for In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to