I graduated from college in 1981 at the very end of the era of inflation and the beginning of the Reagan Revolution in financial markets. Like many of my counterparts at that time, I opted for a career in the markets. Many went to work in the stock and bond sector where a bull market took hold, and asset valuations skyrocketed after the ugly 1970s. I chose what turned out to be an area that would suffer for years. Commodities thrive in an inflationary environment, and inflation became a distant memory as the years went by and the '80s became the '90s and the new millennium.
The price of gold was falling from all-time highs at around $850 per ounce in 1980 when my attention shifted from higher education and the pursuit of a degree to watching price action on a daily basis. In 1981, the price of the yellow metal had declined below $600 per ounce. In 1982, gold fell below $400. For the next decade and one-half, the price of gold traded in a range from under $300 to over $500 per ounce, but the precious metal spent the lion's share of time in a tight band from $300 to $400.
Inflation is traditionally gold's best friend, and these days, after over eight years of accommodative central bank policy in the wake of the 2008 global financial crisis, inflation could be coming back in earnest for the first time in almost four decades in the world's major economies.
The 2% target is a mirage
Inflation can be an insidious beast that can eat away at the value of money. A little inflation can be a good thing for an economy as it is a sign of growth. However, inflation can get out of hand, and that is why central banks around the world pay particular attention to the inflation rate. Since the Fed began hiking interest rates in December 2015, the central bank set a target rate of 2% for inflation.
The Fed recently changed its statement about the target 2% inflation rate from "moving towards" to "will reach," and it is likely that inflation is already higher than the Fed's target. There are many ways to measure inflation, and raw material prices are just one of the methods. However, when looking at the prices of healthcare, educational costs, and even a grocery cart full of food for a family, it has become clear that prices are rising for average Americans. Job growth has been positive over recent months, but wage growth has trailed. The Fed's perception of inflation is rooted in data and calculations, but for most people, things are getting more expensive, and their dollar is being stretched compared to its purchasing power over past years. To me, the Fed's 2% inflation target is a mirage as the cost of living has been moving higher at a faster pace than the Fed seems to believe in its analysis.
Years of cheap money policy in the U.S. and around the globe
The global financial crisis of 2008 and housing crisis in the United States that same year caused the central banks of the world to stimulate economies using historically low interest rates and programs of quantitative easing. The tools at the central banks' disposal stopped the U.S. and many other nations from plunging into a depression or experiencing a prolonged period of deflation and economic stagnation. Interest rates at zero in the U.S. and in negative territory in Europe were meant to encourage borrowing and spending and inhibit saving to jump-start economic growth. However, the flood of money at the hands of central banks has increased the prospects for inflationary pressures as more currency chases finite goods. At the same time, population around the world continued to grow during the difficult economic period, and more people on earth were chasing finite staples.
Interest rates remain at historically low levels today with the Fed Funds rate at only 1% and European and Japanese rates at negative 40 basis points. QE has ended in the U.S., but it continues to the tune of 80 billion euros each month in Europe at least until the end of 2017. Almost nine years since the beginning of the global financial woes, the central banks continue to flood the monetary system with liquidity and the ultimate price is bound to be building inflationary pressures.
The demand for alternative means of exchange on the upswing
Governments have been printing money and making it available at historically low for years which has led to a decline of faith in fiat currencies. The dollar, euro, yen, and other foreign exchange instruments are valuable only because they have the backing of governments, and people have confidence when it comes to the credibility of the countries that print the notes.
Gold traded from $300 to $400 per ounce most of the time from 1982 through 2004. In 2008, it rose to an all-time nominal high of $1,033.90, and in 2011, it peaked at $1920.70. Today gold is around the $1,255 level, which is a signal that currencies are worth a lot less today than they were in past decades. Additionally, a new means of exchange, Bitcoin, the cryptocurrency, has moved from 6 cents in 2010 to recent highs of $1,244.61 on February 27, 2017.
The rise of Bitcoin and the current gold price is a sign of the decline in value of traditional currencies.
Commodities signal inflationary pressures
Raw material prices tend to be some of the best signals when it comes to monitoring economic conditions and inflationary pressures on the economy. In late 2015 and early 2016, the U.S. and global economy faced the risk of deflation as raw material prices traded to multiyear lows. The prices of many of the primary industrial commodities like crude oil, copper and other base metals, iron ore, coal, lumber, and many others reached bottoms and have since exploded higher. Many commodities have doubled in value since the lows.
Appalachian coal has increased in price from $39.55 in 2016 to $55.05, 39.2% higher. Source: Bloomberg
In a sign of demand for dry bulk commodities around the world, the Baltic Dry Index that represents the cost and demand for shipping has increased from 290 on February 11, 2016, to its current level at 1,255. The BDI has more than quadrupled. These are just a few examples of many increases in raw material prices. The 2% Fed target inflation rate could be a mirage as these commodities are signaling that the value of money has declined precipitously compared to raw material prices.
Gold is the ultimate barometer
Gold has increased in value from $1,046.20 in December 2015 to its current price at the $1,257 level, an increase of just over 20%. Gold has also signaled that there is inflation in the global economic system as it has rallied in all the main reserve currencies over recent years.
Inflation can be a wild bronco that destroys the value of money. With all of the liquidity floating around the global economy and raw material prices continuing to post gains, it may not be long before the price of gold shocks many and takes off to the upside. The current critical resistance level for gold is at the 2016 highs of $1,377.50 per ounce. Gold has been slowly gaining in 2017 and it moved just above the medium-term resistance at $1,265 on the news of U.S. bombing in Syria on Thursday April 6 to highs of $1,273.30 on the active month June COMEX futures contract.
As the ultimate barometer of inflationary pressures, the yellow metal could take off to the upside and shock investors and traders into finally believing that inflation is a lot higher than the central bankers are leading us all to believe. Inflation is gold's best friend, and the precious metal is telling us that it is rearing its ugly head and could get out of control in the months ahead. There is a bill that will come due for all of the cheap and easy money policies of central banks. The financial crisis required an aggressive approach from the monetary authorities, but the low rates and QE may have been in place too long and now we should prepare for an expensive bill that is likely to continue to eat away at the value of our money. Gold will be the best hedge when the world finally wakes up and realizes that 2% inflation is in the rear-view mirror.
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Disclosure: I/we 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.