Executive Summary

Gold prices have surged in recent months, which some observers claim is a clear warning that inflation will soon turn sharply higher as it did in the late 1970s. However, other forward-looking market-based inflation indicators do not support this hypothesis. Inflation indicators such as bond yields, consumer expectations and TIPS spreads have been running at fairly depressed levels, which suggest inflation will likely remain benign.1 If the spike in gold prices is not a sign of looming inflation, why are gold prices at a record high?

It appears that foreign central banks may be playing a role in driving gold prices higher. After two decades of reducing their holdings of gold, central bank purchases of the precious metal set a record in July and anecdotal evidence suggests they have continued to buy more recently. In addition, the increase in futures contracts outstanding indicates that speculative activity is also picking up.

Does the apparent attempt of foreign central banks to build up their holdings of gold indicate that they have “lost confidence” in the dollar? Probably not, at least not yet. Foreign central banks appear to be diversifying on a flow basis only because they remain net buyers of U.S. Treasury securities. If foreign central banks had indeed “lost confidence” in the greenback, we think they would be reducing their holdings of Treasury securities. However, indications that the United States is not serious about addressing its long-run fiscal challenges could eventually lead foreign central banks to reassess their willingness to continue financing U.S. government obligations.

Gold Prices as a Harbinger of Inflation

Many recall the gold price spikes of the early 1970s and early 1980s that heralded double-digit inflation months in advance. Indeed, the doubling of gold prices between late 1972 and mid-1973 was followed by a sharp increase in consumer price inflation (Figure 1). That episode in the early 1970s was simply a warm-up act for the early 1980s when gold prices surged to the unheard of price of $650/ounce in January 1980. By spring of that year, CPI inflation was running near 15 percent. Today, the price of gold has been trending higher for a year, and currently exceeds $1000/ounce. Does the recent moonshot in gold prices herald another decade of runaway inflation?

Between the early 1970s through the late 1990s, gold prices and the rate of inflation followed a relatively predictable path. A persistent upward trend in gold prices became a fairly reliable harbinger of high inflation. As such, investors seeking to hedge against inflation flocked to gold, pushing up the price even higher.

Before we all cash in our monetary savings for prized art objects, which were used as an inflation hedge in the 1970s, let's put the current increase in gold prices into perspective. Although the price of gold is currently at a record level, its price changed more quickly in the late 1970s than it has at present. Over the past 12 months the price of gold has risen about 50 percent, a sizeable increase but well short of the near trebling in price that occurred between January 1979 and January 1980. In real terms, the price of gold is about 50 percent below the peak that it reached in January 1980 (Figure 2). Therefore, the inflationary signal that today's increase in gold prices may be sending does not appear to be as strident as the warning sent three decades ago.

Moreover, we are not convinced that the current run-up in the price of gold is indeed associated with concerns about rising inflation, because other early-warning signals of inflation are quiescent at present. Consider Treasury bond yields. The high inflation rates of the early 1980s and expectations that inflation would remain elevated led to double-digit yields on 10-year U.S. Treasury securities (Figure 3). Today, however, the yield on the 10-year U.S. Treasury security is comfortably below 4 percent. Would investors really be concerned about runaway inflation if they are willing to lend money to the U.S. Treasury for 10 years at less than 4 percent per annum? Moreover, the yield spread between the nominal 10-year bond and the inflation-protected 10 year bond, the so-called TIPS spread, is less than 2 percent at present.

The Fed announced in March 2009 that it would buy $300 billion worth of Treasury securities to help hold down long-term interest rates. Couldn't the Fed's extraordinary purchase program artificially reduce Treasury yields and render them useless as an inflation signal? In the absence of the Fed's purchases, wouldn't Treasury yields be higher and investor concerns about inflation be more visible?

Maybe, but the Fed is near the end of its purchase program. It seems that Treasury yields would have already reacted to the well-publicized news that the Fed plans to wrap up its program by the end of October 2009. Moreover, the Fed's total purchases represent only 4 percent of the $7 trillion worth of marketable Treasury securities outstanding. It does not seem likely that the Fed's actions would be able to hold down yields if investors really feared an inflationary outbreak.

Moreover, other inflation indicators are not flashing red at present. There is a question in the University of Michigan's survey of consumer attitudes that measures inflation expectations over the next five years. This measure of inflation expectation rose to nearly 10 percent in the early 1980s, but it has remained remarkably steady over the past decade or so suggesting that consumers do not seem to be too worried about inflation at present (Figure 4). Therefore, the hypothesis that the sharp increase in gold prices recently foretells an episode of rapidly rising inflation does not appear to be supported by other measures of inflation expectations.

Another plausible idea is that the rise in gold prices is due to an increase in risk aversion. In the past, investors have flocked to the safety of gold when they have become spooked. If risk aversion were rising, however, then why have the prices of equities, whose uncertain cash flow characteristics make them among the riskiest of financial assets, increased so much recently?2 The fall in the VIX index, which measures stock market volatility, and the narrowing of credit spreads also indicate that risk aversion is declining, not increasing.

Some Central Banks Are Switching into Gold

If expectations of rising inflation and increasing risk aversion do not appear to be good explanations for the recent run-up in the price of gold, then what explains its increase? We believe that central banks may be part of the story. The price of gold fell to roughly $900/ounce in early July, but it has risen essentially non-stop in subsequent weeks. Interestingly, gold purchases by central banks increased by a record amount in July (Figure 5). Although “hard” data for central bank holdings of gold in August, September and the first few weeks of October are not yet readily available, anecdotal evidence suggests that central banks have continued to purchase gold. For example, a recent Wall Street Journal article noted that the Taiwanese central bank will likely increase the amount of gold in its foreign-exchange reserves.

Why would central banks have an interest in buying gold? Central banks have increased their foreign exchange holding from about $2 trillion at the beginning of the decade to roughly $7 trillion at present, and the U.S. dollar comprises about two-thirds of that total. How many more dollar assets do foreign central banks need? Although foreign central banks continue to buy U.S. Treasury securities - they purchased $53 billion in the 12 months through August 2009 - the pace of purchases has slowed over the past year or so. Foreign central banks are not dumping U.S. assets, but they appear to be diversifying their purchases on a flow basis. Although central bank holdings of gold have trended lower for the past two decades, foreign central banks may be buying gold again as a way to diversify their portfolios and their purchases appear to be contributing to the increase in the price of the precious metal.

Speculators May Be Piling On

It also appears that speculators have thrown their hat in the ring and are helping to push gold prices up even higher. One measure of speculative activity is the number of futures contracts outstanding, so-called “open interest”, on the COMEX exchange. Future contracts allow investors to realize financial gains through price changes without taking physical possession of a commodity. The price of gold and the amount of open interest have been trending higher over the past few years (Figure 6). Since early September open interest has increased by 165,000 contracts, the largest six-week rise in about 10 years. Although commercial accounts (i.e., end users of gold) may be increasing the number of future contracts they buy to hedge against further large price increases, we suspect that non-commercial accounts (i.e., speculators) are also behind the recent increases in open interest and the price of gold.

Conclusions

Some observers have interpreted the record rise in the price of gold recently as a warning that the United States is on the cusp of another inflationary period à la the late 1970s/early 1980s. Unprecedented amounts of liquidity that the Federal Reserve has pumped into the banking system and record budget deficits of the federal government also seem to support the notion that years of crippling inflation may be just around the corner. However, other early warning indicators of inflation, such as yields on U.S. Treasury securities and measures of consumer inflation expectations, do not support the hypothesis that investors are universally concerned about a period of runaway inflation.

Rather, the recent rise in the price of gold appears to be related, at least in part, to attempts by foreign central banks to diversify their reserve holdings on a flow basis. After years of reducing their holdings of gold, foreign central banks bought a record amount of the precious metal in July and anecdotal evidence suggests that their net purchases have continued over the past few months. Speculators appear to be jumping on the pile as well, which also may be helping to push up gold prices. Although it is impossible to determine how much central banks wish to increase their holdings of gold, the big decline in their gold portfolios that has occurred over the past two decades suggests that they have scope to continue buying gold for some time.

Interest by foreign central banks to increase their gold holdings begs a more fundamental question. Have they lost confidence in the dollar? Probably not, at least not yet. As noted above, foreign central banks have purchased $53 billion worth of Treasury securities over the past 12 months. Although the pace of purchases has slowed from its rate of a year or so ago, we think foreign central banks would have become outright net sellers of Treasury securities if they had “lost confidence” in the greenback. Foreign central banks are not dumping dollars, but they appear to be diversifying away from the greenback on a flow basis.

As we argue in a recent report, however, indications that the United States is not serious about addressing its long-run fiscal challenges could eventually lead foreign investors and central banks to reassess their willingness to continue financing U.S. government obligations.4 Although there is little evidence to date to suggest that that point has been reached, the price of gold could skyrocket if foreign governments do indeed lose confidence in the dollar.

Wachovia Corporation
http://www.wachovia.com