Tuesday, May 11, 2010

Easy Fed, easy ECB, strong gold

Today gold bugs are celebrating as the price of gold rises by $30 dollars and €31 euros. Gold has now reached a new all-time against both currencies. In yen, however, gold is still almost 30% below its 1980 high (1980 figures in this chart are month-end, not daily, so the actual gold high was somewhat more than what is reflected in the chart). Thus we see how dramatically the yen has appreciated against the dollar and the euro in the past 30 years. Not surprisingly (since inflation and the value of a currency are intimately related), Japanese inflation has been much lower over this same period than inflation in the U.S. and the Eurozone: since early 1980, Japanese inflation has totaled a mere 35%, while U.S. inflation has been 150% and German inflation 90%.

Supply-siders like me believe that gold is a good common denominator against which to measure currencies over long periods. Currencies that hold their value better against gold invariably have lower inflation than currencies that don't. A corollary to this is that when all currencies decline meaningfully against gold, as they have been doing in the past 4-5 years, then global inflation is quite likely to rise. Given the substantial degree to which currencies have fallen relative to gold since 2005 (a few years after most central banks adopted accommodative monetary policies), we should therefore expect a substantial pickup in inflation around the world in coming years, and the cause will be easy money. Since the end of 2005, gold is up 80% vs. the yen, 120% vs. the euro, and 140% vs. the dollar.

Unfortunately, I am unaware of any formula that relates changes in gold prices to changes in future inflation. The linkage is loose, the lags are long, and there are other things which get into the mix—such as geopolitical risks—that muddy the waters. But if this theory of gold and currencies holds any water at all, we should see rising inflation in the future, and that should be quite a surprise to most global bond markets, since they are currently priced to inflation remaining very low and stable.

By way of illustrating how this process works, I offer the following simple rule of thumb for any central bank desiring to keep its currency stable against gold (and thus replicating a gold standard): add or subtract whatever liquidity is necessary to keep the price of gold within a relatively narrow band. In practice, that means trying to find the short-term interest rate that makes the public indifferent between owning a short-term deposit or owning gold.

If interest rates are too low, gold becomes more attractive and rises; people prefer to hold less money and more gold, and the unwanted money tends also to get spent on things, pushing up their prices in the process (this is similar to the velocity story I have been highlighting in recent months). If interest rates are too high, the public prefers to own bonds rather than gold, and gold prices fall. When gold prices are stable, a currency is "as good as gold;" demand for the currency exactly matches the supply of the currency, and inflation is negligible. The history of gold standards tells us that when implemented correctly, a gold standard is virtually guaranteed to deliver very low inflation.

Is the rise in gold prices a signal to buy gold? Not necessarily. Indeed, I would argue that gold prices at today's levels already reflect a substantial amount of monetary inflation. Inflation almost has to go up to validate current gold prices, and central banks almost have to continue making the mistake of keeping interest rates too low. Gold has had a substantial run, and it can't keep rising at this rate forever. If the past is any guide, gold might rise about 1-2% a year on average over the next several decades. Buying gold today for the long haul is almost certain to be a poor investment, although gold could certainly rise further over the next several months. Gold is going to be the asset most vulnerable to the first indications of central bank tightening, whenever that happens to occur.

Remember when gold used to be worth about $35/oz. back in the1930s, 40s, 50s, 60s, and 70s? Taking early 1940 for purposes of comparison (inflation was about zero that year, after having been negative for most of the 1930s), the U.S. CPI today has increased by a factor of 15.6, while gold has increased by a factor of just over 35 (a strange coincidence). That sounds impressive from gold's perspective, but on an annualized basis, gold has appreciated only 1.2% more than the rate of inflation over the past 70 years, and that's not very impressive. You can't expect that buying and holding gold for the long haul will do better than most alternative investments.

Finally, as these next charts show, the price of gold in constant dollars tends to oscillate around some value (e.g., the real price of gold is mean-reverting) over time. By any historical standard, the price of gold is quite high in real terms relative to its long-term average. (Note that the first chart uses year-end values, while the second chart uses month-end values.)


Benjamin Cole said...

Excellent post. Many assets over the longer haul outperform gold, including property and equities.

The Chinese have become the world's biggest buyers of gold, and ETF gold funds have been created of late. Jeez, gold could have a long run. Obviously, more and more Chinese have disposable income, and they like to buy gold. This could run for decades.

This new reality suggests the link between what the Fed does, and gold prices, gets weaker with every passing year. Within 10 years, the Chinese economy will eclipse ours as the world's largest, and, of course, they have a population of 1.5 billion. They also have a much higher savings rates than the US. Gold prices are determined by what happens in China, not here.

The shape of global capital markets will also be increasingly determined in China. And we have global capital and currency markets. Capital crosses borders more easily than any other product or commodity.

I think this is a positive, though it will be a bruising reality for American sensibilities. Within a generation, China's capital markets will dwarf ours, as their savings rates are higher, and they accumulate gigantic foreign trade surpluses.

This should lead to even higher property and equities prices, globally. The Chinese seem to travel for business--the Chinese diaspora. They buy assets globally, set up businesses globally.

I suspect the coming global boom will dwarf anything we have ever seen.

brodero said...

174 oz of Gold will buy you a median priced new home.....this is
about the same as it was in 1983
when the median priced new home
averaged 75,458 and Gold averaged
423.70 for 1983. Do you want a new home or 174 ounces of Gold?

Anonymous said...

In Germany - gold is sold out. Nearly impossible to get 1 ounce.
People are expecting the worst. It is told, we will switch back to Germany Mark called DM2.

W.E. Heasley said...

Mr. Grannis:

“Unfortunately, I am unaware of any formula that relates changes in gold prices to changes in future inflation.”

Not a formula of gold prices vs. future inflation, but as a current underlying phenomena, future inflation might well be linked to the fact that QE and Keynesian government deficit spending were theories developed in environments of low or no debt yet are theories being deployed simultaneously in a hyper-debt environment.

Putting that fact aside for a moment, governments across the world over many decades have developed debt which has been increasing at an increasing rate. Further, implicit debt (unfunded entitlements) has been increasing at an increasing rate.

When the easy money bubble went bust the first step was to stabilize the economy after the financial crisis brought on by an easy money bubble. The stabilization tools of choice by many policy makers are/were monetary and fiscal policy (QE and Keynesian deficit spending).

Once the economic situation is stabilized, policy makers find themselves in the following bind:

(1) fiscal policy responses to garden variety recessions over many decades and the current financial crisis has accumulated into a mountain of debt. A mountain of debt that is not easily paid off,

(2) decades of constituency building by the progressives in the political class has created entitlement promises that are unfunded and unsustainable.

Hence the Mt. Everest of debt and implicit debt suddenly becomes viable as the fog of political progressivism burns off. QE needs withdrawn and Keynesian government deficit spending begins to wind down. But rather than a low or no debt environment as the theories were developed, the theories are faced with the Mt. Everest of debt looming in the background.

There is a limit to deploying QE and Keynesian deficit spending in an over leveraged environment. You can’t have an environment of unlimited debt and expect QE and Keynesian deficit spending to work. There becomes a point that you are the Weimer Republic and policy responses are a joke. Hence you have to reduce debt or the next financial crisis may lead to melt down with policy responses useless.

It would appear that if no or low debt was the environment, then the theories would play out as theorized. However, with Mount Debt faced by policy makers, it merely opens the path of least resistance for policy makers which is to monetize debt. Debt must be reduced. The pain to pay off debt and truly fund entitlements is too politically poisonous in the short run. Hiding behind monetizing debt and reducing debt through inflation, although not a politically long run viable idea, it’s a wonderful political short run fix.

The short run fix fits politicians. The promises of unfunded entitlements and accumulation of debt through past Keynesian spending programs are monsters created by the ghosts of short run politicians of the past. Those politicians are long gone. Their short run political careers have left the economy with long run debt.

Maybe the formula is not gold vs. inflation but political careers vs. inflation.

John said...

For me the most important takeaway from this post is 'the linkage is loose, the lags are long, and there are other things that get into the mix...'

However, I do believe it is a mistake for investors to ignore the message gold prices send. Today I think the recent panics (Lehman, subprime, etc. here and the sovereign crisis in Europe) are driving people into gold (see Ed's post above). Yet I cannot help but agree that the central bank policies globally have been the biggest factor. Also, the macro nightmare dream weavers have also played a role.

Gold is today a crowded trade. I agree with Scott that one might do well in the short run with it but I think the only way one does really well from here is if the nightmare scenarios constructed by some actually play out as they opine. As I have said before, I still am not convinced that it is how one should bet.

Both England and Spain are announcing significant budget cuts this morning. I continue to believe the riots in Athens with people dying in the streets was THE EVENT that gave the fiscal conservatives the political ammunition they needed to defeat those who opposed spending cuts. I say again, behavioral change has arrived in Europe. The only question that remains for me is, WILL IT BE ENOUGH? We will see.

I am traveling today so this will likely be it for me for now. Have a great day, guys.

Public Library said...

WEH. Great post. Whole heartedly agree.

Scott Grannis said...

Ed: thanks for noting this. I just now saw this:



It would appear that the recent surge in the gold price has a lot to do with fears that the euro will be debased or dissolved. I have to believe that is a low-probability event. I think the advantages of a single currency outweight the disadvantages. But people are clearly very concerned and the level of fear is high.