Gold is a fascinating metal. It has been fascinating us throughout human history, but more so in recent years due to the parabolic rise in its price. This is ironic, because through the larger part of human history, gold did not have a price; rather everything else was priced in gold terms. However, gold's use as a store of value continues till this day as the inflation continues to erode the value of fiat currencies while gold gains in value in terms of these currencies. The only real threat to gold's multi-year rally arose in 2008 when SPDR Gold Trust (AMEX:GLD) dropped more than 25% from July to October on deflationary fears due to the impending recession. However since then, the Federal Reserve has conducted multiple rounds of 'quantitative easing' bond buying programs which have expanded the Fed's balance sheet manifold to unprecedented levels thereby reversing any deflationary fears and raising the fear of higher inflation.
Common economic sense dictates that printing billions of dollars under the name of quantitative easing would depreciate the dollar and generate inflation. And fear of the expected inflation to be caused by all this money printing is the major force that has been driving the rally in gold prices over the past few years. If you follow gold closely, you must have read many gold bugs telling you how QE induced hyperinflation is imminent and therefore the price of gold is about to shoot up. Just recently, I read how the recent weakness in gold price is just a desperate attempt by US monetary authorities to punish savers. But to study the impact of all this quantitative easing on inflation, we must look at how various rounds of bond buying by the Fed have impacted actual inflation as well as inflation expectations. Here is a chart of Core PCE, the Fed's preferred measure of inflation and the University of Michigan one year inflation expectation over the past five years along with a chart of GLD.
Source: Federal Reserve Bank of St. Louis FRED
There are very important points to note from the charts above. Initially when the first round of quantitative easing was launched, we were in the heart of the great recession, the Core PCE was falling rapidly and there was a real danger of the US economy sinking into a deflationary trap similar to that of Japan if the Fed didn't act. This was being reflected in the falling price of gold as well as the falling inflation expectations. You can see that as soon as the first round of bond purchases was announced by the Fed, the trend of falling inflation expectation reversed and inflation expectation started to rise, growing to more than 3% in mid-2010 and before stabilizing in the 2-3% range. During this period, the Core PCE was still only hovering close to 1.5%. But this did not stop gold prices from moving higher, with investors confident that printing of huge sums of money would cause inflation. However, the core PCE started decreasing again soon after the end of QE1 in March 2010.
Not to worry, rumors of a new QE program started making the rounds as soon as QE1 ended and Fed chairman Bernanke's now famous Jackson Hole speech in August 2010 all but confirmed Fed's plans for a second round of quantitative easing. This gave another shot in the arm to the gold bulls. If QE1 was strong enough to prevent deflation in such a severe recession, more money printing in the form of QE2 would definitely bring more inflation, everyone thought. This sentiment was once again reflected in the price of gold which moved sharply higher since the Jackson Hole speech. The rally continued after the confirmation of QE2 in November 2010. Similarly, the one year the inflation expectation also moved markedly higher, rising to more than 4.5% in early 2011 from just above 2% in August 2010. However, the actual inflation as measured by the Core PCE barely moved and continued to linger below the 1.5% level as the GDP growth took a tumble in Q1 2011. The inflation fears receded as the inflation expectation turned lower to stabilize around the 3% mark. However gold prices continued to drive higher as the investors were confident that the unprecedented size of the Fed's balance sheet would start to drive inflation at some point.
In the second half of 2011 and through early 2012, the expansion of the European Central Bank's (ECB) balance sheet due to the EuroZone crisis and the Fed's sterilized bond buying program, the operation twist, continued to support gold but the price action was choppier as compared to the previous years. Moreover, throughout 2012 the fed continued to hint that it would not be opposed to another round of direct bond buying, or QE3, if the economy remained sluggish. And by the end of July 2012 it was quite clear that QE3 was coming. However, you can clearly see in the charts above that something was different this time. Yes, there was a brief rally in gold price in expectation of the QE3 announcement but with two important differences relative to the price action close to QE1 and QE2:
- The size of the rally was relatively small
- The rally fizzled out as soon as the announcement was made and since that time, the gold ETF continues to make lower highs and lower lows.
The difference can also be seen in the inflation chart: unlike QE1 and QE2, there was no marked rise in inflation expectations before or after the announcement. And the actual Core PCE has been in a downward trend since the announcement.
So the question is, why the difference this time?
The above narrative may be that of the impact of quantitative easing on the price of gold, but to me it looks a lot like the parable of the boy who cried wolf. QE1 involved a lot of money printing which, in line with economic theory, caused the investors to fear moderate inflation, but it did not deliver that inflation. QE2 involved even more money printing on top of QE1, but again its potential inflationary impact was nowhere to be seen. Gold, much like the attentive villagers in the parable, jumped on the first two warnings that inflation was coming only to be disappointed later as the warnings turned out to be false alarms. But now after more promised money printing in the form of QE3 and then its extension to QE4, gold is getting increasingly skeptical about inflation prospects. And who can blame it after the recent Q4 GDP number?
So what about the wolf?
If the whole story is to reach its logical conclusion, some time in the near future the wolf of inflation would show up and catch us all by surprise. I have a good theory on why the inflation is not coming and when it will come. But it is a long one so I'll write on that subject sometime later. For now, my advice to gold investors is to pay close attention to price action in GLD. I mentioned above that gold has become skeptical about the whole 'QE will bring inflation' narrative. However, it has still not completely rejected that theory as GLD is finding support near the $158-160 range. You can see in the weekly chart below that GLD is in a triangular formation and has been hovering about its 50 week moving average for the past few weeks now. In my opinion, a break out from this triangle on either side would be important in determining the direction of gold's near term trend. However, for the long term, any further expansion in the Fed's balance sheet should have a diminishing impact on gold prices until there are some signs of actual inflation.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I own physical gold.