Wednesday, May 12, 2010

Gold As Canary In Inflation Mine

Beginning by noting that gold is still 30% below its peak in yen terms, and ascribing it to Japan's much lower long-term inflation rate, Scott Grannis says that gold is clearly signalling for higher inflation down the road.
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....
Grannis, I should add, doesn't think much of gold as a long-term investment at these levels. He thinks that substantial inflation is already priced into the metal as of now.

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