Inflation Expectations and the Price of Gold

From a long-term perspective, gold is a bargain at recent prices in the $900 to $930 an ounce... and will remain so even as it begins to move into a higher trading range.

Recent gold-market developments and technical price action — along with broader economic and financial-market developments — suggest that gold is bracing for a resumption of its long march upward and a retest of its historic high in the months ahead. For more, see our recent posts on NicholsOnGold.com, particularly Risk/Reward Ratio Favors Long Side and Gold: A New Monetary Role.

First and foremost, the bullish outlook for gold rests on the increasing likelihood of accelerating U.S. inflation in the years to come — and an associated unprecedented rise in investor demand for the yellow metal.

This nascent inflation has not yet been reflecting in world financial markets. But, judging from anecdotal evidence and the financial press — and the warnings of a growing number of institutional investment managers — we believe a gradual, subtle, but important, upward shift in inflation expectations is already underway.

Inflation Expectations

Inflation doves (and others fearing imminent deflation) point to the currently low, almost negligible, rates of consumer price inflation and the narrow interest-rate spread between ordinary U.S. Treasury securities and U.S. Treasury Inflation-Protected Securities (TIPS) as evidence that inflation and inflation expectations remain subdued. This — along with other important factors that we’ll discuss in subsequent posts — has helped keep gold prices down in recent months.

We think those looking at the U.S. Consumer Price Index are focused on the wrong inflation indicator. Instead, a look at the gross domestic product price deflator, a broader, more reliable, and less volatile inflation indicator — rising at an annual rate of 2.9 percent in this year’s first quarter — should be enough to put fear in the hearts of economic policymakers... but, as far as we can tell, they’re looking at the CPI and still worrying more about deflation.

Importantly, in our view, if only a small percentage of investors become worried about inflation, gold could, and likely will, benefit long before any sign of a broad-based rise in inflation expectations appears in the interest-rate differential between ordinary Treasury securities and TIPS, the so-called TIPS spread.

Because of the relative size of the markets, a small shift of investor interest toward gold can have a magnified effect on the metal’s price... but the same small shift in interest away from ordinary Treasury securities in favor of TIPS may have no noticeable impact on relative interest rates between the two types of securities.

Similarly, even a small reallocation of investment funds away from equities or corporate bonds or other “conventional" assets because of rising inflation or inflation expectations (or for any other reason) into gold may be a big deal for the gold market without producing much of a negative effect on other asset markets.

In other words, by the time the broad financial markets register a worsening of inflation expectations gold will have already made a major move to the upside. It provides an early warning or leading indicator of inflation, signaling the coming acceleration long before financial markets begin to quiver.

Fuel for the Fire

As sure as night follows day, the Federal Reserve’s purchase of bonds and home mortgages and the resulting rapid increase in bank reserves (quantitative easing in Fed-speak) — unless soon reversed — is underwriting a coming acceleration of inflation.

And, with a consensus in Washington and around the country that the quickly expanding Federal government deficit should be financed by central bank purchases of Treasury securities, there seems little likelihood that quantitative easing will be replaced with quantitative tightening until well after inflation has accelerated to disturbingly high rates.

President Obama’s own Office of Management and the Budget (OMB) now estimates a Federal budget deficit of $1.84 trillion for the current fiscal year ending September 30. This is equivalent to 12.9 percent of the overall economy or gross domestic product — and, by this measure, the biggest deficit since World War Two. Early estimates for next year put the deficit at 8.5 percent of GDP.

Many economists generally consider that a country’s deficit should not exceed three percent of GDP. Whatever the appropriate ratio, for sure this year and next, the Federal government deficits will remain beyond the norm and will require massive Federal Reserve purchases of Treasury securities in order that interest rates remain low enough to accommodate economic recovery.

Disclosure: No positions

Comments

[DONE_SONZ:]

Inflate and debase.

May 14 10:07 AM

[opinionated:]

"...gold could, and likely will, benefit long before any sign of a broad-based rise in inflation expectations appears in the interest-rate differential between ordinary Treasury securities and TIPS, the so-called TIPS spread."

The TIPS spread has steadily increased since it bottomed in February 2009. I leave you to your own conclusions...

May 14 10:22 AM

[altaman:]

Nice work Jeffery! This is a clear and concise explanation of what is currently going on on the inflation front, what is on the horizon and how the POG will be affected by inflation perceptions (got gold and/or silver and/or miners of same?).

May 14 10:56 AM

[ozzy43:]

Straw man argument. Analysts like Mish Shedlock make a compelling case for deflation - and it has nothing to do with looking at the CPI. If the author is willing to thoroughly address the arguments Shedlock makes, I'll be interested in reading it, but this post adds little to the debate.

May 14 11:34 AM

[Market Sniper:]

Complex issue: Deflation vs. inflation. Mish is correct in that what we are now seeing due to credit collapse is almost classic deflation. Everything you own and owe on is dropping in price. One must look at the response to this deflation. What do we see? An insane attempt to reflate or at least stop the sliding housing prices and prop up dead banks. By massively borrowing (actually creating "money" out of thin air through the central bank) the federal government is creating a situation that is far worse. ALL hyper inflations come out of the worst business conditions. We are used to a benign type of inflation. A hyper inflation is not a monetary event, it is a currency event. Just because they are not creating more M Zero (paper and coin in circulation) does it mean that digital "money" will not cause a hyper inflationary blow off and a currency collapse? History teaches us otherwise. There are CONSEQUENCES for what is being done here.

May 14 06:29 PM

[Russell Ups...:]

In Jim Rogers' recent Bloomberg interview, he said he preferred silver to gold because the IMF was desperately trying to sell its gold. Not according to the IMF website:

www.imf.org/External/N...

May 15 12:57 AM

[onebir:]

" Not according to the IMF website"

Really? It says that the IMF's the 3rd largest official holder of gold in the world & has been planning to sell 1/8 of its holdings for a while. The G20 supports this plan, but the IMF needs US approval (because the decision requires an 85% majority, & the US has a 16.7% share of the Exec Committee vote.) Obama sought the ago-ahead from congress a month ago.

If/when they'll get round to selling the gold - maybe someone more familiar with US politics can comment on how likely congress is to grant approval? - they'll *try* to limit the market impact. But they do want to sell quite a bit...

May 15 11:27 AM

[Tony Daltorio:]

Mish and all the other deflationists are to be polite - fools. They believe the US government.

Pick whatever number you want on what was lost in the credit bubble collapse - 50 trillion, 100 trillion, whatever crazy number you want. It will take the Federal Reserve a nanosecond to "create" that amount of money out of nothing.

Yes, I know that they haven't done that yet. Yet is the key word. Yes, I know doing that would be crazy but when all else fails they most likely will do that.

And your or Mish's argument why the Fed won't do that? Because the government is a wise and prudent steward of our economy and the Dollar?? If you believe that, I have a AMC Gremlin car that I'd like to sell you.


On May 14 11:34 AM ozzy43 wrote:

> Straw man argument. Analysts like Mish Shedlock make a compelling
> case for deflation - and it has nothing to do with looking at the
> CPI. If the author is willing to thoroughly address the arguments
> Shedlock makes, I'll be interested in reading it, but this post adds
> little to the debate.

May 15 03:18 PM