Gold And Price Inflation... And Credit Inflation

Includes: GLD, IAU, PHYS
by: John M. Mason

Gold, to many, is a hedge against price inflation. It is a commodity. It, historically, has been used to back paper money. And many in the investment community see it as a way to protect oneself from rising prices.

Thus, when price inflation is expected, the price of gold goes up. When there is little or no price inflation, the price of gold goes down.

Last week, the price of gold went down, experiencing a two-day drop of more than $200. Michael Mackenzie writes in the Financial Times: "The virtues of gold as an investment sharply divides opinion, but no investor can ignore its stunning fall from favor over the past week."

Going further, he states:

"In the current climate of easy money from central banks, investors are right to worry that the distortion of asset prices is no golden era.

As risk managers examine the scale and speed of gold's sudden and unexpected descent, a logical reaction is to ask whether such an episode could erupt in other asset classes, such as equities and bonds whose prices are being buoyed on a tide of central bank liquidity."

Does this move mean that the investors in gold see a breakdown in their expectation that price inflation is collapsing? That maybe, just maybe, the United States economy is not going to be subject to the inflationary binge many of these investors had believed in?

Some investors began to get worried about price inflation in early 2009. The reason these inflationary expectations grew was the quantitative easing on the part of the Federal Reserve. The balance sheet of the Federal Reserve exploded and many of these investors believed that all the reserves the Fed put into the economy would, at some time, translate into higher and higher inflation.

The bottom of the gold price trough came in October and November of 2009 when the price of gold was around $710 an ounce. As can be seen in the chart, the price of gold rose steadily through until late August 2011 when the price of gold almost closed near $1,900 per ounce.

Since this date, the price of gold traded within a range, with the top of the range being around $1,800 per ounce to a low in the $1,530 to $1,540 range in December 2011 and then again in May of 2012. It stayed in this range until one week ago, April 15, when the price dropped to close in London at $1,395. Its low close was on April 16 at $1,380 and then rose slightly to the end of the week when it closed slightly over $1,400 per ounce.

What's going on here? The Federal Reserve has not backed off. The third round of Quantitative Easing, QE3, is still going on and is expected to last into 2014. What has happened to inflationary expectations?

Well maybe, just maybe, these "gold bug" investors are beginning to realize that price inflation is not a necessary outcome of monetary expansion. The last twenty-some years have shown that the monetary actions of the Federal Reserve and the fiscal actions of the federal government can produce a substantial amount of credit inflation without creating price inflation in the process.

I have just reviewed the book "Profiting From Monetary Policy" and in this book, the author claims that the Great Moderation was "one of the largest ever credit booms in financial history" (Page 158). That is, there was little or no price inflation, but there was a substantial amount of credit inflation.

That is, the efforts of the federal government and the Federal Reserve pushed money into credit markets and so we got bubbles in the stock market, in commodities and in housing markets, but this inflation came in asset prices… not inflation in the price of goods and services used in consumption and investment. Hence, the Great Moderation.

In other words, the liquidity injected into the financial system stayed in the financial sector and did not move into the "real" sector, into the sector of the economy producing goods and services.

The rise in the price of gold topped out in August of 2011. QE2 began in November 2010, but by the third quarter of 2011, it had become pretty obvious that the quantitative easing on the part of the Federal Reserve was having little or no effect in getting the economy to grow faster and unemployment to show any substantial drop.

If you look at how to profit from monetary policy, you draw the conclusion that you don't invest in gold because price inflation is not the threat of the future. If credit inflation is to be the outcome of the Fed's policy, then you go for financial assets and get away from any investment in gold.

In 2012, the price of gold, as described above, fluctuated between $1,530 and $1,800. But it was going nowhere. Meanwhile, investors started reporting substantial gains in other areas, especially in financial assets. I have written about this throughout 2012.

On April 15, investors broke through the bottom of this range and the price of gold dropped by $140. My take on this is that more investors came to the realization that credit inflation was the game in town and not future price inflation. To comment on this, I wrote "Credit Inflation has Definitely Returned".

This seems to be the world of the near future. The actions of the Federal Reserve have created a severe credit inflation and this credit inflation is staying in the financial markets with very little spillover into the "real" sectors of the economy. Thus, we will not see a substantial increase in economic growth and we will not see a renewal of more rapid price inflation. This is not good for the price of gold.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.