Thursday, September 3, 2009
The first chart focuses on the 8 1/2 year rally in gold prices. It started shortly after the Fed eased interest rates in early January '01, which they did because it was obvious by that time that the economy was rapidly weakening. As they dropped their target rate from 6.5% to a mere 1.75% over the course of 2001, gold prices began to gain traction. Commodity prices didn't hit bottom until November '01, but then they too started to rise. Nearly every commodity in the world enjoyed robust price gains for the next seven years.
Gold peaked in early March last year, and then commodities peaked in July, as a brewing financial crisis and a faltering economy caused the world's demand for money to rise. Even though the Fed had lowered its target rate to 3% early last year, a surge in money demand overwhelmed the system, with the result that money was scarce while commodities were plentiful. (In other words, money can become tight if the Fed fails to expand money supply sufficiently in response to a rise in money demand.) That condition, in turn resulted in a huge decline in commodity prices that wasn't reversed until a few months after the world's central banks force-fed bank reserves to the banking system.
With the temporary disruption of last year out of the way, but with central banks still very accommodative, commodities prices have been rising for the past nine months. Monetary policy is easy and money velocity is starting to turn up, and the combination is making money once again plentiful. It's not hard, in other words, to understand why commodity prices are rising. And they will probably keep rising until central banks once again step on the monetary brakes.
(Apologies to those out there who are still having trouble finding money to borrow, but money can be in abundant supply yet difficult to borrow. That's not a paradox, but rather a description of an economy that no longer wants to hold all the money that it has hoarded, but is still hesitant to lend that money to borrowers who aren't rock-solid or through channels that are not well-understood. It just seems easier to load up on commodities, gold, or equities when unloading money, rather than loading up on construction loans to XYZ Corp.)
The second chart puts gold prices into a long-term, inflation-adjusted perspective. Gold prices peaked in January 1980 at $850. In today's dollars, that would be equivalent to $2,300. (The chart shows a peak of $1,800 because it uses month-end data.) So in rough terms, let's say that gold today is worth about half of what it was at the peak of the inflation fears in early 1980.
Gold prices rise when there is "too much money" in the system; when people fear that an excess of money will depress the value of their money. Gold prices also rise when people are just plain scared about something going very wrong. By early 1980 we had all the makings of a perfect storm for gold prices: the dollar's value had been devastated in the prior decade; inflation had risen to 15%; commodity prices were surging; and the Fed was in the early stages of experimenting with a new technique to control inflation. Plus, we were at the tail end of the Carter administration and government was in disarray.
Could gold rise above $1000? Why not? Could it get to $2000? Perhaps, but I think things would have to get an awful lot worse than they are today.
Posted by Scott Grannis at 9:30 AM