What Investors Should Know About Inflation, Interest Rates, And The Gold Price

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Includes: GLD
by: Tim Iacono

The subjects of inflation and interest rates often come up when investors begin considering whether or not precious metals are fairly priced. You really can't "value" gold in any traditional sense of the word, however, there are many clues as to whether its current price is reasonable, one of which is the level of real interest rates as detailed here not long ago.

Since the last vestiges of the gold standard were abandoned in 1971, low or negative real rates have consistently been associated with rising gold prices and high real rates have been associated with falling prices.

That much is clear.

Another important point to consider is the general direction of inflation and nominal interest rates. In a world full of paper money and interest rates at or near zero, a jump in inflation even from low levels can spur gold buying and, as we've learned over the years, when the Fed just hints at raising interest rates, this can send the gold price sharply lower over the short-term.

Since the gold price peaked in mid-2011, inflation hasn't been much of a concern in the U.S. It's dropped from a year-over-year rate of almost four percent back then to about two percent today and, without a move higher, it will be difficult for precious metals to mount much of an advance.

As shown below, interest rates aside, there has been a good correlation between inflation and the gold price, one that would appear even better on a more granular scale. For example, in 2011, both year-over-year inflation and the gold prices rose throughout the year and then plunged in the closing months, in contrast to what appears below.

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With government reported inflation today at around two percent and, importantly, absent any outside systemic shocks, the 7 to 9 percent annual gains that have been seen in recent years might be about the best that gold can muster until the inflation rate begins rising again.

This still beats many other asset classes, but some investors have become used to the double-digit gains seen during most of the last decade and, without higher rates of inflation, that may not be possible again.

A more important consideration here is what might happen when higher rates of inflation someday arrive. This is not guaranteed (and one has only to look at Japan to see how long inflation and interest rates can stay low), however, with the Federal Reserve promising to print a trillion dollars a year until such time that the economy improves, my guess is that we are not going to have to wait too long.

One of the key things to look for when, someday, we begin approaching the end of the current long-term bull market in precious metals is for rising inflation to be accompanied by warnings from the Fed.

History shows that inflating asset bubbles don't really kick into high gear until policymakers begin to take steps to slow the trend, only to find that their timid steps reinforce the very trend they are trying to slow as investors and speculators become emboldened, pushing prices even higher.

The Fed funds rate rose steadily with the gold price in the late-1970s until Paul Volcker became Fed Chairman in late-1979 and crushed inflation (and metal prices) by jacking up short-term lending rates to nearly 20 percent in early-1980. More recently, neither the Nasdaq bubble or the housing bubble really got going until monetary policy tightened as shown below.

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This process may already be underway in Asia where investment demand for gold and silver has reached new highs and, as is the case for other aspects of the global economy, this part of the world may be in the driver's seat when it comes to pushing gold and silver prices to their secular peak. In both China and India, there are now early signs of "gold fever" with new investment products being launched almost weekly and soaring demand from individuals from all socioeconomic levels.

Rising inflation in this part of the world is a key factor in this development and this is why, in my view, we are likely to see the real "gold mania" begin to develop first outside of the U.S. This contrasts with conditions here in the U.S. where, despite record prices for some commodities and oil prices that are now back over $90 a barrel, policymakers are still more concerned about de-flation than in-flation.

Recall that the 1980 price peaks for gold and silver came at a time when consumer prices had been rising for years. The inflation rate reached 11 percent after the first oil-shock in the mid-1970s before falling and then surging again later in the decade under the disastrous Fed chairmanship of Arthur Burns, only to climb to more than 14 percent just as precious metals reached their highs in 1980.

But, inflation is calculated much differently today than it was thirty years ago, so I'm not sure that it's possible to have a government reported inflation rate of 14 percent anytime in our future. For example, as shown below, the shelter component that included home prices rather than today's nefarious "owners' equivalent rent" accounted for nearly half of the 14 percent inflation rate in 1980.

Combine this major change with others such as hedonic adjustments, product substitution, et al, and government economists may have succeeded in guaranteeing that we'll never see double-digit inflation again.

Nonetheless, inflation rates of six or eight percent in the U.S. will likely feel about the same way that 14 percent inflation felt thirty years ago and, as shown in the first chart above, it's worth noting that gold's biggest annual gain in the last decade came during the same year that inflation was highest - in 2007.

Perhaps more importantly, inflation rates that have regularly been at six, eight, ten percent, or more in China and India in recent years will drive policymakers to further tighten monetary policy there and likely lead to higher metal prices.

Whenever it is that gold and silver begin their final ascent, there should be clear signs that the end is near - maybe not so much in the U.S., but certainly in China and India. Owners of funds such as the SPDR Gold Shares ETF (NYSEARCA:GLD) would do well to pay close attention to developments there.

Disclosure: I am long GLD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I also own gold coins.