High gold price, with low inflation?

[mrwheatabix]

Harry Browne stated that gold was for times of inflation. The people who say gold is in a bubble state that there is low inflation, so therefore gold should not be this high. I am trying to figure this out, and I have some theories and wanted to get some opinions here. Theories:
1. Gold is responding to the FUTURE POSSIBILITY of inflation
2. Food and energy are higher, not reflected in CPI, therefore gold is higher (seems to have abated recently, though)
3. Health care and college education is rising at 7% per year, costing families a lot of money, a form of inflation , therefore higher gold price.
What do you guys think is the reason ? Other theories ?

[moda0306]

All that plus negative real interest rates = gold going up.

Not much else to say... also, since fiat currencies depend on faith in central banks, that being at an all time low, this might be another factor.

[edsanville]

Food and energy are reflected in the CPI.  It's the "core CPI" that omits them.

[murphy_p_t]

its helpful to define inflation. If you define it as increase in the money supply, we've already had lots of inflation...gold price may just be reacting to that inflation of the money which supply which has occurred thru actions by the Fed.

[moda0306]

I'm not in the mood for a big debate but I'd say the money supply has only really grown if you think of money in a very limited way.

When the fed buys short-term treasuries with cash during a deleveraging it's hardly a vast expansion in the money supply the way, say, dropping cash from a helecopter would be.

That said, if the effect of the aforementioned bond-buying lowers interest rates below real-yield then murphy and I are saying the same thing but from opposite angles.

[Gumby]

I believe James Grant once said that since Gold doesn't produce anything, it's virtually impossible to determine its real value. It's priceless.

Also, Gold responds to fear. Fear is difficult to quantify in a formula.

[Wonk]

mrwheatabix,

HB was probably trying to make as simple an explanation as possible for brevity's sake.  As we've seen, there can be an environment with low inflation and rising gold prices.  As moda mentioned, the majority of the issue can be explained with real interest rates being positive or negative over a sustained period.  If positive, there isn't much use for gold.  If negative, there's a use for gold since purchasing power is being robbed. 

Also, gold can rise if there's increasing fear of a hard default if high inflation is not an option--like Greece.  Keep in mind gold price movements (much like equity price movements) act like a giant pendulum--typically lasting 10-20 years before changing course in a major way.  When confidence in a monetary unit is rising, the gold price typically falls further away from historical money stock ratios.  Conversely, when confidence is falling, the gold price moves closer and closer back to those same (or very similar) ratios.

[melveyr]

This is my take on gold's recent action:
http://www.stableinvesting.com/2011/09/ ... sures.html

[MediumTex]

My intuition is that the Fed would need to take actions approximately 10x larger than it has to create the kind of inflation everyone fears.

From my perspective, all the Fed has really done is throw a few floaties into a pool of drowning bankers.  It feels like the Fed has done a lot because in normal times it would have been a lot.  In an environment like we are in, however, with deflationary feedback loops getting more traction every day (especially in the areas of home prices and wages), I would say the Fed has taken pretty small steps really, just enough to keep things from falling apart completely.

I tend to agree that gold's price action in recent years has been the result of a combination of negative real interest rates and fluctuating future inflationary expectations.  As far as real inflation where you go to the store and prices are consistently rising from week to week and month to month over an extended period, that simply hasn't happened.  Instead, we have seen pockets of inflation here and there, but since people have less money in their pockets due to static wages, high unemployment and contracting credit, there is really no mechanism to drive inflation; instead we get a few months of inflation, the economy turns sour, and the prices of many items begin falling again. 

Remember, too, that we are also in the middle of an enormous and generational aggregate demand dampener in the form of the baby boomers moving into a much lower consumption stage of life.  That problem would be with us whether or not we had gone through a financial crisis in 2008.  It just happens, though, that post-financial crisis economies and a retiring baby boomer economy are both fundamentally deflationary, so in many ways Bernanke is actually trying to mop up two tidal waves hitting simultaneously armed only with his monetary policy Sham Wows.

It seems to me that the average household could really use some inflation right now.  Most households haven't really saved that much and have huge amounts of debt.  If someone has income of $5,000 a month, and $3,100 of that is debt service in the form of mortgage payments, car payments, credit card payments and student loan payments, it seems to me that some real inflation where prices and wages rose in tandem in an upward spiral like we saw in the 1970s would actually be very helpful to people who are struggling under crushing (but relatively fixed) debt loads. 

In my example, if the prices of the goods and services the average household spends its $1,900 of non-debt service monthly income on go up 20% to $2,280 and household wages go up 15% (because wage gains will typically be outpaced by inflationary price increases) to $5,750, it seems to me that such a household would be better off because it now has $2,650 of non-debt service income each month ($5,750-$3,100) to spend and what it used to buy for $1,900 now only costs $2,280.  In this scenario (which seems pretty typical to me), the average household would have an extra $370 to spend on other stuff every month, even after the inflation has been factored in.  Since most of these households have saved very little money the effect of this inflation on their savings wouldn't be that big a deal.  For people with significant savings, hopefully they have good inflation protection in the form of a strategy like the PP.

I'm not saying that inflation isn't a disaster over time, I'm just saying that when you have millions of people on the edge of bankruptcy because they are struggling to pay a fixed amount of debt service that is not matched up very well with their actual income levels, sooner or later something has to give and it is going to either be inflation or mass defaults, and neither of these options is very appealing, but we are going to have to choose one of them.  If I had to pick I would choose mass defaults--let the lenders take the hit for the risk they assumed when they made the loans in the first place.  However, I know that the financial interests around the world will pull every power lever they have to prevent such mass defaults, and that only leaves inflation as a possible way out of this mess.  The example above just demonstrates how for many families inflation might actually make things a bit easier since they don't really have any assets other than their home to be devalued, and they have already lived through several years of watching their home's value decline every year.

[Kshartle]

I think most people really underestimate the amount of inflation we've suffered at the hands of the Fed this past decade. We often confuse inflation with price increases. Inflation is really the expansion of the money supply and we all know it's been expanded greatly in the past ten years, probably more than 10% per year. That inflation is reflected in Gold. It's also been reflected in some other items like education where production hasn't increased substantially and demand hasn't decreased. Obviously the CPI is a government fantasy number so throw that out the window. Inflation doesn't always equal higher prices. I believe consumer products have experienced consistent price declines in Japan despite Yen prining. Obviously plasma TVs drop in price every year even though the money supply isn't decreasing. The price of goods is set by supply and demand (and government tampering), but Gold is a little different. Gold is money. Gold captures inflation and productivity gains. Other goods are affected by production and consumer demand.

In short I believe gold's run up reflects real inflation and productivity gains which make real money more valuable. I don't think it's anywhere close to a bubble. Wait until people start fleeing treasuries and interest rates rise like in the seventies. The only alternative to that will likely be lots of bond-buying from the Fed. Either of those could push gold into a buuble similar to '80-'81. There's no telling what price an ounce will be in dollar terms. At that point it won't be a question of how high gold can go but how low the dollar can go.

[jackely]

It seems to me that the average household could really use some inflation right now. 

As I'm nearing retirement I am struck by how different things are from when my parents got ready to retire over 30 years ago. Those were terrible economic times too but the bulk of my parent's retirement nest egg was directly related to the inflation of that period, with CD's nearly doubling in value every few years and their property selling for a price they probably never dreamed of.

Where is Paul Volcker when you need him?

[moda0306]

kshartle,

Here's the thing with the fed... when it prints money, it doesn't just toss it from helecopters, it trades it at FMV for short-term bonds (until recently where it went long-term).

Short-term treasuries are almost like cash anyway.

If the fed's mechanism for expanding the money supply were helecopter-esque, I'd have a much easier time accepting the inflation argument, but it's more difficult when they're trading cash for what is essentially a CD at FMV.

[HB Reader]

It seems to me that the average household could really use some inflation right now. 

As I'm nearing retirement I am struck by how different things are from when my parents got ready to retire over 30 years ago. Those were terrible economic times too but the bulk of my parent's retirement nest egg was directly related to the inflation of that period, with CD's nearly doubling in value every few years and their property selling for a price they probably never dreamed of.

Where is Paul Volcker when you need him?

jachh --

That's a good observation.  The investing environment 30 years ago was different, although just like today some groups seemed to suffer unfairly while others seemed to benefit unduly.  I'm struck by how no one came anywhere close to guessing how the next 30 years would turn out.  What a long strange trip it has been.  I know it's a little off topic, but a retrospective:

The high interest rates in 1980-82 greatly benefitted many seniors rolling over their savings into high yielding CDs.  People were buying and selling homes for unheard of prices (although the high interest rates were beginning to bite).  For fixed income investors the great fear was that interest rates would keep rising.  Cash in the new high yielding money market funds was king.  Many considered LTTs "certificates of guaranteed confiscation" and, "everyone knew" inflation and interest rates would push higher in the years ahead.  Although gold and real estate prices were slowly sliding from their all-time highs, few people were predicting a new long term bull market in LTTs or plain old US common stocks.  One of the hottest investments being touted by the brokerage industry to "sophisticated investors" was limited partnerships investing in commercial real estate, equipment leasing, oil drilling and other esoteric endeavors (like jojoba farms) which had leveraged and convoluted financial structures designed to avoid high marginal income tax rates and exploit exotic tax loopholes.  Of course, these partnerships came with huge fees and expenses -- some disclosed, most hidden.  Few investors ever made any money from these products.     

At that time, the CPI was widely considered flawed -- because it "overstated" inflation.  Many considered this a cynical and deliberate ploy by Washington to buy the votes of seniors (benefitting from the high money market rates) and federal retirees and social security recipients (benefitting from COLAs).  The Fed Chairman was ridiculed by many in the press and Congress as being insensitive and completely out of touch with the average American.  Before the 1980 election, the Republicans charged that the young, the unemployed, people looking to buy their first homes and many others were being screwed by the Carter administration.  After President Reagan took office in 1981, the Democrats made the same charges against the new administration.  Ahh, those were the days!

As it turned out, Fed Chairman Volcker, appointed by a Democratic President, held his ground long enough to reverse the trend of inflation (although he stopped short of truly slaying the beast).  The new Republican President Reagan led the successful charge to reduce ridiculously high and injurious marginal tax rates (although he didn't exactly slay the deficit beast).  And a military buildup (which actually began in earnest under President Carter in early 1980 after the 1979 Soviet invasion of Afghanistan, but was greatly accelerated by President Reagan) began that resulted in the military/industrial complex for the next 30 years laughing all the way to the banks (who were just starting their own extended party that didn't exactly end very well).   

During those 30 years, the only truly forseeable development was that the Republicans and Democrats would each take credit for the good years and blame the other for the recessionary years and, of course, that nasty rising national debt.

Who knows, in 30 years our children may long for a Fed Chairman like Ben Bernanke, appointed by a Republican and renominated by a Democrat.  The world is a strange and unpredictable place.     

           

[stone]

Clive, everything in your post makes sense but what is the alternative you would prefer? The long term "traditional" method for monetary policy seems to be to paint yourself into a corner and then have a war and kill everyone and confiscate everything and then debt forgiveness seems by the by. Personally I'd love to have a system that was designed in the hope of being sustainable indefinately. Something like moving tax to being on assets rather than on transactions might indefinately keep  in balance the ratio of global asset value to global non-FIRE-sector GDP. I totally expect that such an unpalletable  approach  won't ever be adopted though.

[Kshartle]

Short-term treasuries are almost like cash anyway.

I realize that the fed expands the money supply by purchasing treasuries and doesn't just drop a stack of bills on doorsteps, but that is still inflation. You can't go to the grocery store and buy food with treasuries nor can you buy gold with it. It's not cash.  You have to use federal reserve notes. The fed creates them, buys the bonds and now cash has replaced the notes on the balance sheet of Goldman or wherever the bonds were purchased. The treasuries exist the same as they did before, there's just more cash in the system because the Fed invented it just the same as you or me running a printing press in our basements. If gold is $100 an ounce and the fed doubles the money supply and everything else remains the same (political strife, inflation expectations, the global supply of gold etc.) the price should be expected to move to $200.

Inflation has been very high this past decade, higher than overall price increases in consumer goods. Computers, communication advances, robotics, cheap foriegn labor etc. have kept prices from rising as fast as inflation. Without inflation overall prices should be dropping at an increasing pace reflecting productivity gains. If you price anything (other than apple stock) in terms of gold this past ten years thenprices have been dropping. Gold is real money and it's captured the Fed's money creation. Look at Gold in terms of Swiss Francs, not nearly the same rise. What's the difference here? Dollar printing as a percentage of total dollars has been much greater than Swiss Franc printing.

[stone]

Kshartle, CHF hasn't been the only strong currency. The Japanese are black belt 7th dan money printers and the Yen has strengthened. I guess the Austrian School definition of inflation is increase of M0 but that is hard to equate to what people actually pay for stuff. If the consequence of ballooning M0 is largely to just have the velocity of base money drop and drop then that complicates the situation. I can see what moda means when he says that STT are quite like base money if you are a bank. Clearly you or me can't buy stuff with treasuries but banks can conjure up money themselves. They can just make loans with the stroke of a pen. They are happy to do that if they have treasuries in return.  If the extra monetary base is largely in the hands of banks that are already not liquidity constrained then it has little impact. I guess though that although banks may be not liquidity constrained for making loans to the real economy, the sky is the limit when it comes to deploying liquidity for trading. They will be able to be ever more bold when inducing price spikes and crashes for their pillaging purposes I guess.

[moda0306]

Kshartle,

True, you can't buy groceries with bonds, but the fact that a bond (desired savings) has been taken off the market to inject something more liquid implies that the balance sheets of the banks involved haven't really changed, and if there are balance-sheet issues in the economy, cash will suffice as an asset.  So while you're right that there's more potential legal tender ready to hit the system, it's still being saved by the same people that were saving w/ short-term bonds before.  When we're well above the fed's reserve requirements, increasing those reserves isn't going to spur mountains of new lending.  People need a reason to take the money out of that system, and that reason would be demand.

Further, I'd beg to differ that those bonds TRULY still exist... the fed claims them on their "balance sheet," but I don't think the fed's balance sheet truly represents assets and liabilities as we'd identify them on our own.  For all intents and purposes, they destroyed the bond and created the money... though they'll have to technically "receive" cash from the treasury at some future point to redeem the bond they "hold."

Demand could be much more easily spurred at this point by slashing taxes and increasing spending... therefore it's deficits, IMO, not monetary policy in a balance-sheet recession (when "monetary policy" implies mostly buying short-term debt with printed cash) that will drive whether we pay more for our stuff.

I don't see the mere existence of reserves as creating inflation... it may make people nervous about it and therefore increase commodity speculation, but I don't get the feeling that can last forever without that cash actually "hitting the streets," as eventually people will get sick of speculating that money popping out of banks when it never actually happens.