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One of the most important drivers of the rise in gold prices since the end of the Great Financial Crisis has been the fear of impending inflation. The gold bulls (AKA “Gold Bugs”) believe that the key source of this inflation will be an increase of the willingness of governments to accept inflation in order to get out from under their rising debt obligations. They argue that the debt levels are so high that they can never be paid back – so they will simply unleash inflation to bring down their level of indebtedness. That is, they will pay off their debt with increasingly devalued currency.

In inflationary periods, gold tends to prosper as its traditional role of being “hard currency” takes on a greater level of importance. We only need to look back at the period from the 1970s to 1980. As inflation was brought back under control in the major industrialized countries, gold began an almost twenty year bear market.

To be sure, the inflation argument cannot be dismissed out of hand. After all, the debt levels are enormous for some countries and they could use all the help they can. To some nations, perhaps a little inflation seems like an enticing option. However, as the data from the OECD compiled below shows, the deficits – while considerable – are not insurmountable. Many nations were in similar budgetary positions in the early 1990s.Canada’s deficits at that time were comparable and in some cases greater than the levels facing many countries today.
General Government Financial Blances - as a % of nominal gdp
Other data from the OECD shows that even though debt burdens are at record highs, interest costs are not rising. This is due to the low interest rates in nations such as the UK and the US. It is because of these low interest rates that the gold bulls also take the central banks to task.

There is no central banker who receives more criticism from the gold bulls than Ben Bernanke, the head of the US Federal Reserve. The Fed's critics believe that its unprecedented expansion in the monetary base of the US economy and the purchasing of all kinds of US government and financial sector debt it did to force interest rates down is bad policy. They believe that the Fed simply bailed out those responsible for the financial crisis and these measures will eventually usher in inflation.

However, it could be that the inflation fears are a little ahead of themselves at this time. The global economy is still quite weak as unemployment reaches a 26 year high, banks are still reluctant to lend and consumers around the world seem to be gripped by fear once again. Recent consumer confidence data from the US shows this clearly as it dropped to a ten month low – leaving many on Wall Street scrambling for possible explanations.

At this point in time, it seems that the Fed and other central banks are doing what they have to do. As some call for gold to reach levels of $2000 per ounce or more – it would be best to step back and take an inventory of the facts. This is not to dismiss the arguments of the gold bulls. They are not altogether invalid. But for the kind of inflation to take hold that would result in an upwards explosion of gold prices from current levels, the Federal Reserve and other central banks would have to throw in the towel and abandon the fruits of the hard won victory against inflation almost thirty years ago. At this point, it would seem that a policy error is a more likely reason for inflation getting out of control rather than outright indifference.

What they must do is to ensure vigilance against inflation, communicate to the markets that they are steadfast in their commitment to maintaining price stability and demonstrate that they are willing to stand up to political pressures to keep interest lower for longer should it no longer be prudent to do so. In addition, it must be made clear that the policy response from central banks was unprecedented but so was the depth of the financial crisis.

On the fiscal policy side of the equation, governments will have to raise taxes and cut spending as gingerly as they can. Any government which states that they only have to cut taxes and the road to reducing government deficits will be painless is simply not being straight with its citizenry.

Disclosure: No positions held

Source: Fear of Inflation Driving Gold Prices