Appealing To Occam's Razor to Explain Gold Above $500

By: Paul Kasriel | Sat, Dec 10, 2005
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On Wednesday, December 7, the London pm gold fix was $515.40 per troy ounce - the highest dollar price of gold since April 6, 1981. The dollar price of gold began a noticeable ascent in 2002 as the foreign-exchange value of the dollar began a noticeable descent. From 2002 through 2004, while the dollar price of gold was rising, the foreign-currency price of gold was relatively stable. This year, the foreign-exchange value of the dollar has risen, but so, too, has the dollar price of gold. In other words, in 2005, the price of gold has risen not only in dollar terms, but in terms of most foreign currencies. Why?

Gold is a sterile asset. It pays no dividend or interest. Gold's appeal as an investment asset comes into play when central banks no longer provide for a positive inflation-adjusted return on short-term investments - that is, when the yield on the central bank's policy interest rate (or some related money market rate) is below the inflation rate. In this case, gold becomes a better store of value than short-term money market instruments denominated in fiat currencies. Gold soared to a record high price in 1980 after a number of years in the early 1970s of central banks keeping short-term interest rates below inflation rates. As the charts below show, history now is repeating itself, at least qualitatively. That is, the rate of wholesale price increases, which tend to be less hedonicallyadjusted than the rate of consumer price increases, is far in excess of the level of central bank policy interest rates or related money market interest rates. Moreover, it is not clear that central banks are in a mood to rectify this situation. For example, although the ECB just raised its policy rate by 25 b.p. to 2.25%, it indicated that this could be a case of "one and done," probably because of political pressure. The Bank of Japan (BOJ) has recently been verbally signaling a 2006 rise in its policy rate. But the Japanese Ministry of Finance has simultaneously been verbally signaling a revocation of the BOJ's independence if it does raise rates. In the UK, with the economic growth decelerating, the debate seems to be more about when the Bank of England will cut interest rates again rather than will it will raise rates. And perhaps most importantly, the November 1 FOMC minutes hinted that the Fed is nearing the end of its tightening campaign. And, of course, the Fed seems fixated more on "core" concepts of price increases, which have been "better behaved" than more inclusive concepts.

So, we do not have to conjure up a lot of convoluted hypotheses as to why the price of gold is soaring against paper currencies. Rather, we can appeal to Occam's Razor (Google it) in coming up with an explanation - global investors are losing faith in, as Jim Grant calls them, faithbased paper currencies as a store of value.

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Paul Kasriel

Author: Paul Kasriel

Paul L. Kasriel
Director of Economic Research
The Northern Trust Company
Economic Research Department
Positive Economic Commentary
"The economics of what is, rather than what you might like it to be."
50 South LaSalle Street, Chicago, Illinois 60675

Paul Kasriel

Paul joined the economic research unit of The Northern Trust Company in 1986 as Vice President and Economist, being named Senior Vice President and Director of Economic Research in 2000. His economic and interest rate forecasts are used both internally and by clients. The accuracy of the Economic Research Department's forecasts has consistently been highly-ranked in the Blue Chip survey of about 50 forecasters over the years. To that point, Paul received the prestigious 2006 Lawrence R. Klein Award for having the most accurate economic forecast among the Blue Chip survey participants for the years 2002 through 2005. The accuracy of Paul's 2008 economic forecast was ranked in the top five of The Wall Street Journal survey panel of economists. In January 2009, The Wall Street Journal and Forbes cited Paul as one of the few who identified early on the formation of the housing bubble and foresaw the economic and financial market havoc that would ensue after the bubble inevitably burst. Through written commentaries containing his straightforward and often nonconsensus analysis of economic and financial market issues, Paul has developed a loyal following in the financial community. The Northern's economic website was listed as one of the top ten most interesting by The Wall Street Journal. Paul is the co-author of a book entitled Seven Indicators That Move Markets.

Paul began his career as a research economist at the Federal Reserve Bank of Chicago. He has taught courses in finance at the DePaul University Kellstadt Graduate School of Business and at the Northwestern University Kellogg Graduate School of Management. Paul serves on the Economic Advisory Committee of the American Bankers Association.

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The information herein is based on sources which The Northern Trust Company believes to be reliable, but we cannot warrant its accuracy or completeness. Such information is subject to change and is not intended to influence your investment decisions.

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