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The Supply-Side Conundrum: Rising Gold and Higher Interest Rates

By Paul Hoffmeister

The United States has entered the early stages of a significant inflation, but the economy will be in even more trouble if the Federal Reserve raises short-term interest rates to combat the problem.

The 75% surge in gold since 2004 from $400 per troy ounce to more than $700 today has been a sure sign that inflation is on its way. Always the first metal to move higher during an inflation episode, the gold rally in previous years foreshadowed and preceded the booms in oil, natural gas, copper, silver, corn, dairy and a multitude of other commodities which tend to quickly follow gold. Everyday household goods, newspapers, and regulated prices lay at the other end of the price spectrum where prices are slow to adjust to gold. Yet, so long as gold remains above $600/oz, these "stickier" prices will also rise to catch up to gold. We are already seeing some adjustments. General Mills' recently announced they will reduce the amount of cereal within their boxes but will keep prices the same; Dow Jones has raised newsstand prices of the Wall Street Journal to $1.50 from $1.00; and U.S. postage stamps have risen more than 10% in the past year and will surely rise even more.

But gold-signal skeptics argue that the yellow metal is no different than other commodities whose prices are being driven higher by rising demand from Asia, and therefore they say, gold-based inflation fears are overblown. But history suggests otherwise.

As the chart below illustrates, movements in the gold price have preceded every significant inflation episode measured by the PCE since 1971. Today, the dollar-based economy is in another period in which gold is preceding an impending inflation. The disconnect between gold and the statistical inflation measures favored by policymakers is large. At $700/oz., spot gold is implying an approximate annual inflation of 5.25% during the next 10 to 15 years while various core PCE measures estimate current inflation within the range of 2.0% to 2.3%. In other words, while official indices offer the veneer of price stability, gold is warning global markets that the dollar is sinking as a store of value.

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Gold's unique power to signal inflations and deflations is rooted in the very concept of money. Money, a medium of exchange, enables humans to avoid direct barter trading by using paper money that represents a specified amount of gold. Since the tenure of Alexander Hamilton up until 1971, U.S. currency was essentially backed by gold, except for few brief periods such as the Greenback era spawned by the Civil War. Even though dollars are no longer redeemable for gold from Fort Knox, the dollar still represents a specific amount of gold. Today, at $700 gold, the dollar allows individuals to avoid direct barter trading by using Federal Reserve notes worth approximately 1/700th an ounce of gold. The function of money and its relationship to gold explains why J.P. Morgan said, "Gold is money! That's it."

Importantly, gold is not prone to changes in either supply and demand like other commodities. Annual gold production is roughly 2% of total existing stock, and the metal has very few industrial uses, except for minor cases in dentistry and specialized electronics. On the other hand, more than half of the silver (the most monetary commodity besides gold) produced last year was used in industrial applications. Additionally, the gold futures market is the only commodity future to never backwardize, which means a sudden surge in demand or shortfall in supply has never been able to cause spot prices to exceed future prices. Therefore, supply/demand dynamics in the gold market have never meaningfully pushed around gold prices. As a result, the gold surge in recent years has not been caused by a surge in demand from rapidly growing economies such as China and India - contrary to many economists' arguments today.

Instead, when the dollar price of gold rises or falls, it means the value of the dollar is changing. The increase in the price of gold indicates the Fed has been supplying the economy with too much money and inflating the dollar. A decline in price indicates the Fed is not supplying enough and deflating the currency.

The tame statistical inflation measures today, such as the PCE and CPI, are misleading. They do not accurately capture changes in quality or adjust to sales and discounts. And weightings in these "price baskets" are held for long periods of time and do not adequately reflect substantial changes in consumer preferences and living costs. For instance, a consumer shift from pricey filet mignon to less expensive pork sausage is not reflected, even though such behavior might normally suggest a decline in living standards. Consequently, the PCE and CPI lag true inflation/deflation realities and appear artificially smooth.

So with gold at 27-year highs signaling inflation, how do we get out of this monetary predicament? Some economists and market pundits are quick to argue the Federal Reserve should raise short-term interest rates to combat any incipient inflationary pressures. Popular thinking believes that higher short-term interest rates would tighten the monetary spigot and decrease the over-abundance of money supply.

But a higher "price" for shorter-term credit does not guarantee a meaningful deceleration in money supply growth, or an essential reduction in the gold price. Reserve bank credit, the root of all money creation and a proxy for money supply, is currently expanding at an approximate annual rate of 3.0% compared to 4.6% in June 2004. This is a paltry difference given the 425 basis point increase in the funds rate. And the 75% depreciation of the dollar in gold terms during the last 3 years proves the Fed continues to flood the economy with too much money.

Most rate hawks fail to acknowledge that the typical slowdown in economic activity produced by higher interest rates causes the demand for money to decline. Given that the price of gold is determined strictly by the supply and demand for dollars, a negligible change in the money supply along with a decline in money demand equals a net oversupply of money. In other words, higher interest rates do not combat inflation but arguably worsen the problem when economic growth is harmed as a result! The significant rise in gold between the summers of 2004 and 2006 to $700 from $400, while the funds rate soared to 5.25% from 1.00%, supports this. But, as the Fed held the funds rate steady at 5.25% during the last year, gold has generally held firm in the mid $600 range as the economy regained its footing.

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Similar to how the last year's relatively stable gold price coincided with a stable fed funds rate, an interest rate cut could arguably cause inflation and the gold signal to fall if economic growth and animal spirits were incentivized enough to increase money demand and absorb some of the excess liquidity permeating the economy. This argument rests on the supply-side principle that new economic growth at the margin is in fact a disinflationary event.

The Federal Reserve could also take a more direct approach by targeting a $500 gold price and selling bonds to immediately drain the excess liquidity from the economy and allow the market to freely set interest rates. Doing so would remove the guesswork out of the hands of Fed technocrats in determining the appropriate balance between the supply and demand for dollars.


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