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Everyone's Favorite Inflation Indicator
Wall Street economists watch it. Main Street businessmen watch it. Even Alan Greenspan reportedly watches it. The price of gold is considered by many to be a reliable leading indicator of inflation.
For several months the Federal Reserve has been raising interest rates because of concern that inflationary pressures in the economy are growing. So one would expect the gold price to be rising as well. But it isn't. Except for an occasional bounce, gold has been mired under $300 per ounce for more than two years. So what's wrong with everyone's favorite inflation indicator? Or is it possible that the price of gold is telling the true story and Federal Reserve policy is misguided?
It would be comforting to think that the gold price is still doing its time-proven job, and that its current lackluster price is signaling that there is no inflationary threat. However, while that interpretation may be comforting, it doesn't jibe with some important facts.
For example, the up-trend in the Employment Cost Index (ECI) considered by many to be one of the economic reports most closely watched at the Fed is well established. While the 1.4% jump in this index in the first quarter was one of the larger increases in recent years, the up-trend in the ECI actually began in 1997.
Another concern is rising commodity prices. Crude oil prices, though down from their recent peak, are still up substantially from a year ago. The Commodity Research Bureau Index is up 23% from its February 1999 low and at 2-year high. Because this index of 17 different commodities is broad-based, the run-up in the CRB cannot easily be blamed on bad weather, poor crops or a jump in energy prices. The consistent rise in this index for more than one year can mean only one thing the Dollar is being inflated.
And sure enough, a quick glance at monetary and credit indicators show rapid expansion. Bank credit so far this year is growing at a 10.5% annualized rate, and M3 growth is again on the upswing after a few months cooling off from last year's torrid pace which produced some double-digit annualized growth rates.
So it is understandable that the Federal Reserve has been raising interest rates in an attempt to control resurgent inflation. But why is there no response from gold? Is inflation a threat or isn't it?
When it comes to markets, no indicator is infallible. So maybe inflation really is a threat, and the abeyant gold price is giving a false signal. And indeed, there are new factors, not heretofore an influence, that appear to be affecting the gold price.
Before we tackle that issue, consider first that gold itself can become overvalued as it obviously was at its $850 peak in 1980 or undervalued like the $35 price in the late-1960's or even the $100 low it touched in 1976. But the price of gold is not the same thing as the value of gold, which like any other commodity, good, or service can from time to time be overvalued or undervalued. Consequently, it is incorrect to look at the price of gold without also considering whether it is relatively cheap or expensive in dollar terms. Adjustments to the price of gold are needed to make it a consistent measure that transcends time. So it is not the 'price' of gold which is a good inflation measure. It is the 'real' price of gold that is useful in determining whether the dollar is being inflated.
The accompanying chart presents the real price of gold, as determined by the Consumer Price Index. There are two different starting points. The dollar/gold exchange rate was $20.67 in December 1933, and then $35 in January 1934 after the 69% devaluation of the dollar by President Roosevelt. Given the flow of gold out of the Federal Reserve before the devaluation and the reversal of this flow after the devaluation, it is clear that gold was undervalued at $20.67 and overvalued at $35.
Adjusting with the CPI, it now takes $456 to purchase what one ounce of gold bought in 1934 or $270 to purchase what one ounce bought in 1933. Which of these two measures of the real price of gold is more useful? I recommend using both of them.
Referring again to the chart, it is obvious that when gold falls to or below the bottom line, gold is very good value, even undervalued. When gold rises to or above the upper line, it is becoming overvalued. Right now this chart is saying that gold is good value and should therefore be accumulated. But what does this chart say about inflation?
Forget about the current price of gold. Look at where the price of gold should be as determined by the CPI. Just as $20.67 was too cheap and unsustainable in the early 1930's, so too is today's $270 CPI adjusted price. But if $456 seems high to you, then a mid-range price of $363 is arguably a reasonable measure of inflation adjusted purchasing power. The fact that gold is below this $363 price is only an indication that gold is out of favor and/or other factors are affecting its price it is not a signal that inflation is under control.
While this first chart implies that gold may be out of favor, the second chart, which presents the monthly CRB index and gold price, indicates that other factors are at work here on the gold price. Note the clear historical pattern. When the gold price rises (points A, C and E), the CRB follows. Then gold falls (B and D), and again the CRB follows. In the early 1990's at points D and E, the relationship is less clear. I believe that hedging by mining companies and others who have borrowed and then sold gold caused the pattern to change. But even with some distortions, the relationship nevertheless has remained more or less the same gold leads and the CRB index follows.
Recently, however, the historical pattern has changed markedly. Note the difference at point F compared to the other turning points on this chart. Gold has been going nowhere, but the CRB is rising rapidly.
Given the above, it is logical to ask whether the historical relationship between gold and the CRB Index has ended. I don't think it has ended. Gold still is money, so it still is sensitive to
inflationary pressures of the Dollar. So why isn't gold leading the CRB Index higher as experience and logic say it should?
Gold has stopped leading the CRB for the moment because new factors are affecting the gold price. And two of these stand out derivatives and central banks.
A well researched report prepared by Reginald Howe for www.GATA.org analyzes the semi-annual global OTC derivatives positions compiled by the Bank for International Settlements. At the end of 1999, the BIS numbers indicate that the total notional amount of gold derivatives to be just under 28,000 tonnes, a weight almost equal to the total gold reserves of the world's central banks.
While there are various implications of this derivative position, one fact is clear. It is the nature of markets and derivatives that there no doubt exists a naked short position. Even if the naked shorts were only 10% of the total exposure which is probably at the low end of expectations the naked short position is greater than annual mine production.
Thus, the gold market is in a dangerous imbalance. It is vulnerable to a short squeeze because there is not sufficient new mine supply for the naked shorts to meet their obligations to deliver metal. The metal they require can at best only partially be filled by new mine production. So instead the shorts must rely on a sharp rise in the gold price to bring metal into the market by inducing the strong hands accumulating gold at these low prices to exchange their bullion for dollars.
In this regard, last September's $60 3-week spike in the gold price may be prologue. The jump caused the shorts to rush for cover, but the inordinate 21% annualized rise in derivative positions in the last half of the year suggests that the shorts may have opted for 'Plan B'. Rather than bidding the price up higher to encourage dishoarding of metal, the shorts wrote more paper to force the gold price back down in an attempt to control their losses. The first quarter derivatives report prepared by the Office of the Controller of Currency provides further evidence for this conclusion.
Gold derivative positions of reporting banks surged in the quarter from $87.6 billion to $95.5 billion, a 36% annualized rate of growth. Upward pressure in the gold price continues be hit with unprecedented amounts of paper. By throwing this paper into the gold price equation, the shorts may have won a battle, but the alarming increase in the short position makes it increasingly unlikely that they will win the war.
Another factor affecting the gold price is central bank lending. In Congressional testimony in July 1998 Alan Greenspan said that "central banks stand ready to lease [i.e., lend] gold in increasing quantities should the price rise". He should know because 2150 tonnes of gold owned by foreign nations had been shipped from the Federal Reserve mainly to Europe from 1990 to July 1998. At least another 500 tonnes has been shipped since Mr. Greenspan's testimony.
While some of this gold was dishoarded by central banks in well publicized sales, no doubt much of this gold has been loaned into the market, as Mr. Greenspan observed. But did his testimony serve another purpose? Was it an indication that Mr. Greenspan is no longer watching the price of gold because it is being affected by anomalous factors? Alas, as with so much of Federal Reserve policy, we have more questions than answers. But regardless, there is enough evidence to suggest that the price of gold is not providing the warning about inflation that it should be, and as it has in the past.
If gold were trading here without the burden derivatives and central bank lending have imposed on it, it's price would probably be a lot higher. In fact, just by looking at past patterns of gold in relation to the CRB Index on the accompanying chart, one can easily see that gold should now be somewhere north of $350 per ounce, given the recent jump in the CRB.
Would this jump in the gold price be a signal of resurgent inflation? Well, yes, it would, but this time around everyone's favorite inflation indicator would be lagging not leading the inflation that has already begun.
James Turk writes the Freemarket Gold & Money Report <www.fgmr.com> in North Conway, New Hampshire. He is also the founder of GoldMoney.com
