In the early 1980s the Fed stopped the wage-price spiral and therewith it destroyed the gold price. Today main-stream economists have discovered that rising company profits compared to stagnating wages could be an issue for the U.S. economy. For us this implies that the ultimate Fed goal will be to increase wages and inflation. Consequently the Fed has become the biggest supporter of gold and silver prices.
In one of our most popular posts we explained that:
Going into more detail, the six major fundamental factors that influence gold and silver prices are:
- Price movements of other commodities in combination with global demand for these commodities, an "indirect pricing" of production costs.
- Global, and in particular U.S., inflation.
- Trade imbalances as well as the U.S. debt and twin deficits, which might culminate in a "fear factor".
- Central bank activities like money printing or gold purchases and sales.
- Real interest rates and in particular the ones in the U.S.: interest rates compared to inflation and wages.
- Private physical demand and supply.
Why have gold prices plummeted?
The plummeting gold price since 2011, from levels around 1900 dollars to 1200 today, was mostly due to the following reasons:
- European austerity and low demand weakened current account surpluses of China and other emerging markets (factor 3 in the list above).
- Wage increases in emerging markets, in particular in the "BRIIS" (Brazil, Russia, India, Indonesia and South Africa), and to a lower extent in China, were too high. This finally affected their trade balances (factor 3) and the previously high gold demand by their central banks (factor 4). Austerity and tightening in these countries led to a phase of global disinflation that was negative for gold prices (factor 2). Higher oil supply through shale oil additionally slowed the commodity-dependent countries among them.
- Lower growth in emerging markets, restrictions and tariffs on gold purchases (e.g. in India) weakened physical demand for gold (factor 6) and demand for oil and other commodities (factor 1).
- Thanks to QE3, the U.S. housing market recovered. This reduced the "fear factor" (factor 3). Finally it helped increase investments, job creation in the United States and raised U.S. real interest rates (factor 5).
- Many of these points were "self-reinforcing" and led to a vicious cycle for gold prices: in 2011/2012 European austerity slowed investments in Europe and later also in emerging markets, but it strengthened investments in the U.S. and the U.S. dollar.
In 2010/2011 Fed's QE2 helped to create overinvestment and a price-wage spiral in emerging markets that finally culminated in a gold bubble. But the yellow metal remains in a long-term bull market.
In the following we want to examine in more detail factor 5, real interest rates - the difference between U.S. interest rates and inflation. Over the longer term inflation is mostly driven by wages.
Gold and silver prices rise with falling U.S. real interest rates, with "financial repression"
Still today, American funds are the most important driver of financial markets. Therefore gold and silver prices fall when investing in U.S. treasuries becomes relatively more attractive than in gold or silver. In times of high real interest rates, the gold price is weak, and vice versa.
The following graph gives a bit more differentiation. It shows periods when the simple relationship stipulated in this point gets overlaid:
- by factor (1), the development of commodity prices and global growth - between 2005 and 2007 (despite positive real interest rates) and
- by item (2), when inflation rose more quickly than rates - between 1977 and 1980 (despite slightly positive real interest rates).
The gold price falls when the U.S. economy improves and the chances of a Fed Funds rate hike increase, even if this hike is far in the future. Particularly when more U.S. jobs are created, then gold and silver prices decline.
Wages as the underlying factor for interest rates and the gold price
During the 1970s, inflation expectations and consequently wages rose in response to oil shocks and rising oil prices: the price-wage-spiral: rising wages increase disposable income, thus raising the demand for goods and causing prices to rise. Rising prices caused demand for higher wages, which led to higher production costs and further upward pressure on prices. The gold price moved upwards together with wages and oil prices.
Fed chairman Paul Volcker finally hiked interest rates, slowed the economy and increased unemployment with the consequence that unions stopped higher wage demands. New supply (e.g. North-sea oil) suppressed the oil price. Low commodity prices and high rates created a lost decade for Southern America. Global growth was sluggish during the 1980s and the Fed managed to keep inflation under control. Company margins and stock prices rose again, the Fed had destroyed the gold price.
In 2013, the opposite picture has arrived: U.S. wages have been nearly steady for years, but company margins are still increasing. The wage share of GDP is declining, while companies profit on global supply chains and cheap labor in emerging markets. One mastermind behind the Fed, Paul Krugman, has spoken out in favor of rising wages, and more and more economists have recently joined the chorus.
source Paul Krugman
After having achieved considerable improvements in the unemployment rate, they want more from the Fed. The Fed typically implements the ideas of economists like Krugman, hence you can be sure that the Fed will continue the stimulus for years. We judge that the central bank will continue to support the U.S. and the global economy as long as inflation is low, no matter how low the unemployment rate sinks. The main Fed gauge, the GDP deflator for personal consumption (PCE) currently stands at 1.4% and is far under the target value of the Fed's Evans rule of 2.5%.
In our post why the euro should reach 1.50 in the next years, we explained why the way to higher U.S. wages in global competition is very long. Therefore, it is clear for us that Bill Gross is right with his "Reverse Volcker Moment": the Fed will keep rates low until finally inflation moves to 2.5%. At this relatively high inflation level, however, stock markets typically depreciate and gold prices rise. It is hence clear for us that:
The Fed should continue to support rising inflation, suppress real rates and consequently support gold prices for many years.
P.S. Timing of the gold and silver purchases:
We judge that 2014 will be another year of U.S. unemployment reduction and once again wage increases will be limited. On the other side, current account surpluses of emerging markets should further shrink because wage and inflation expectations in these countries are still too high. Therefore we expect higher stock prices and a lower gold price also in 2014. However it makes sense to buy stocks of emerging markets (NYSEARCA:EEM). Gold has not bottomed out yet, but from then it should go for multi-year bull market helped by the Fed.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.