GOLD PRICE NEWS - The gold price spiked higher, up $10.17 to $1,083.01, heading into the open as investors bid up weak dollar beneficiaries such as the price of gold, gold mining stocks, and commodities such as oil and copper. The U.S. dollar declined marginally versus the euro as traders unwound a portion of the record short position in the euro following this morning’s announcement that the European Union (EU) would “take determined and coordinated action if needed to safeguard the euro area as a whole” according to EU President Herman Van Rompuy. Although details were minimal, should the uncertainty of whether Greece will receive EU support be removed, the euro as well as risk appetites would likely rise. This would support the gold price as well as global equities and commodities.

The price of gold, in addition to oscillating due to Europe’s travails, fluctuated yesterday following the public release of the prepared statement Federal Reserve Chairman Ben Bernanke was scheduled to present at a Capitol Hill hearing that was postponed due to poor weather. In the statement, the Chairman Bernanke began to outline the long-anticipated “exit strategy” for unwinding the unprecedented array of special liquidity programs the Federal Reserve instituted in order to combat the global credit contraction.

While reiterating that economic conditions are “likely to warrant exceptionally low levels of the federal funds rate for an extended period,” Bernanke described a few of the policy tools the Fed can employ to check inflationary expectations as the economy recovers and strengthens.

One such policy tool is the payment of interest on bank reserves, an option not available to the Fed before October 2008. Increasing the rate paid on reserves would reduce the supply of credit through the banking system and dampen credit demand by effectively raising rates on other financing instruments. Another policy tool would be the use of reverse repurchase agreements, which the Fed has used at times before to drain reserves from the banking system, albeit never before on the scale that would be necessary to achieve the reserve reduction requirements that now faces the Fed.

The central bank is also developing an instrument similar to certificates of deposit for member banks, which would convert reserves into deposits - but could not be used to count toward reserve balances. Bernanke’s statement noted that these policy tools could be deployed in concert to drain hundreds of billions of dollars of excess liquidity form the banking system in a short period of time.

The implications for the U.S. dollar and the gold price in implementing an exit strategy depend on both how effectively the Fed’s new tools work as well as the market’s confidence that the policy objectives are achievable. If the market has the confidence that the Fed will be able to effectively drain the system’s excess reserves and unwind its $2.3 trillion balance sheet, then the U.S. dollar would likely rally and the gold price could be expected to come under pressure.

Any divergence from the current ultra-easy monetary policy has the potential to alter inflationary expectations enough to stall the current gold bull market and usher in a period of volatility until visibility over the direction and efficacy of Fed policy improves.

But having a plan and executing it effectively are two different things. The Federal Reserve and Chairman Bernanke are walking a tightrope between unleashing a fierce tsunami of price inflation down the road if it is too restrained in checking excess liquidity as the economy heats up, and choking off the recovery and plunging the country back into recession if it is too aggressive. If the economy dips again, the past eighteen months have demonstrated the lengths central bankers and politicians will go to liquefy the system.

The most anticipated information for market watchers and investors was missing from the Chairman’s testimony: when the exit strategy will commence. For now, the Fed is sticking with its nearly year-old language of “for an extended period” in reference to the committee’s zero rate policy. Furthermore, no exit is in sight for unwinding the toxic assets purchased under the Fed’s quantitative easing programs.

Without guidance as to the timing of the exit strategy, the markets may very well revert to the previous trend of upside price action in assets that benefit from U.S. dollar depreciation. The gold price and the shares of gold mining producers would fall into this category. Despite the 10-week sell-off in the gold price, the global macroeconomic situation remains favorable - and until talk becomes action, gold bulls remain in the driver’s seat.