The gold price bounced back above $1,100 per ounce this morning after sliding $7.90 in overnight trading. Gold mining stocks have been weaker on a softer gold price and tumbling equity markets. As measured by the Market Vectors Gold Mining ETF (GDX), gold stocks are off 14% in the past 10 trading sessions. Global equity markets have declined for six consecutive days, using the MSCI World Index as a benchmark, on continued uncertainty over the pace at which Chinese authorities will restrict monetary policy. Following last week’s announcement that reserve requirements would be increased, rumors of bank lending curbs have been making their way across global trading desks. The public battle over the confirmation of Federal Reserve Chairman Ben Bernanke has added to worries over tighter monetary policy in China, helping to spur the liquidation of stocks, commodities, gold, and the shares of gold mining producers.

Concerns about a deeper correction in riskier assets grew as Jeremy Grantham, the co-founder and chief investment strategist of GMO - a Boston-based institutional investment management firm - released his latest quarterly letter. In his piece, titled “Stop the Presses,” Grantham penned a scathing analysis of the Federal Reserve and its role as the main culprit of the financial and economic problems of the past decade.

Mr. Grantham pointed out that while the economy has responded each time the Fed has stimulated it with low rates and a rapid expansion of the money supply, financial markets have continually exaggerated these positive effects while the real economy has responded in a more reluctant manner. Moreover, Grantham chastised the central bank for being “reckless in facilitating rapid asset booms in the tech and housing bubbles.” Grantham went on to suggest that the Fed policy has been geared to “ameliorate the pain of any setbacks should asset prices reverse course and collapse.”

The GMO strategist criticized the Federal Reserve and Chairman Bernanke’s stubborn refusal to acknowledge that these asset bubbles even existed. Grantham commented that “up until the last few months, I was counting on the Fed and the Administration to begin to get the point that low rates held too long promote asset bubbles, which are extremely dangerous to the economy and financial system. Now, however, the penny is dropping, and I realize the Fed is unwittingly willing to risk a third speculative phase, which is supremely dangerous this time because its arsenal now is almost empty.”

By the “arsenal” being empty, Grantham was referring to the unprecedented fiscal and monetary policies utilized by Bernanke to stem the deflationary headwinds that emerged as the credit crisis put the entire global financial system at risk. Specific policies have included the Federal Reserve slashing interest rates to near zero and implementing a $1.25 trillion quantitative easing program - a sophisticated term for printing money.

The Fed has denigrated the value of the U.S. dollar and fueled a rise in real assets, such as gold and shares of gold mining producers. As the opportunity cost of money has slid as real interest rates turned negative, the allure of an asset such as gold that pays no rate of interest increases. The gold price rose 281% over the past decade and the shares of gold mining companies have risen at a multiple of this figure.

Grantham makes the argument that the Fed has effectively run out of bullets and going forward will be ill-equipped to deal with another asset bubble like the one that is potentially forming. The investment implications of a scenario in which the Fed struggles to deal with the bursting of a third asset bubble could be significant. Accordingly, Grantham proffers his bearish view on equities and other risky assets. While he does not comment specifically on the gold price or gold mining stocks, if 2008 is any indication, both would likely decline in the initial deleveraging phase. However, the policy response - again using the past decade as an indication of the official response - would likely be a continued expansion of the money supply through new quantitative easing programs and more aggressive fiscal stimulus. This prescription would create further pressure on the U.S. dollar and likely lead to new all-time highs in the price of gold.