[OPE] Gold speculation and prices

via Antonio Pagliarone

ECONOMICS CORRESPONDENT:
David Uren | February 16, 2009
Article from: The Australian

GOLD has been the standout performer in an otherwise bleak
investment market in the past three months as investors punt on the return
of inflation.

The gold price tumbled alongside other
commodities until November, when the talk of a new stimulus package in the
US and the election of President Barack Obama sparked a switch in the
investor mood.

The price has since risen by a third to almost
$US1000 an ounce. Gold bugs are filling the internet with speculation of
prices north of $US2000 an ounce, while broker Merrill Lynch has tipped it
will top $US1500 in 12 to 15 months.

Gold investors are
betting that the policy flexibility being exercised by governments and
central banks worldwide, led by those of the US, will result in their loss
of control over the value of money. This up-ends the prevailing wisdom
about the Great Depression: that its severity was caused by policy
inflexibility created by the rigid link between currencies and the gold
standard.

The gold price fell from its all-time high of
$US1009 an ounce in March last year to a low of $US706 by November. It was
up to $US810 by the middle of last month but has since climbed strongly,
reaching $US950 last week amid concern about US policy action.

The US stimulus package is likely to push the US budget deficit towards
$US2trillion, or almost 15 per cent of its shrinking GDP. In principle,
this should have no implications for inflation. The deficit is simply an
effort by the public sector to offset some of the rise in private-sector
savings resulting from the collapse in consumer demand.

Concern that difficulty in funding the deficit may lead to a collapse of
the US dollar is also likely to be misplaced. The fall in US treasury bond
yields last year, with 10-year bonds dropping from 4 per cent to a 2.1 per
cent, was driven by massive demand.

Economist with the Council
of Foreign Relations Brad Setser says outstanding treasury bonds rose by
$US1.7 trillion last year, of which China accounted for only about $US375
billion.

Even if foreign demand for US bonds falters in the
face of the massive supply, the slack can readily be taken up by the US
Fed, which is already considering the option of investing in US
treasuries.

However, it is the idea of central banks stumping
up the funds needed by governments to cover their deficits that has gold
bugs worried by inflation.

Morgan Stanley's well respected
global fixed interest economist

Joachim Fels says high
inflation, and even hyper-inflation, defined as prices rising by more than
50 per cent a month, are outside possibilities as the global crisis
unfolds. "The root cause of hyper-inflation is excessive money supply
growth, usually caused by governments instructing their central banks to
help finance expenditures through rapid money creation," he writes.

He says the are three preconditions.

First, the
rapid expansion of the monetary base under way in the US, Britain and
Europe would have to continue and lead to an expansion of money in the
hands of the general public. Secondly, governments would have to face
difficulty financing their stimulus and bail-out packages through taxes
and bond issues to the public, resulting in political pressure for central
banks to pick up the shortfall.

And finally, the combination
of sustained monetary growth and big fiscal deficits would have to
undermine public confidence in their governments' ability to service the
debt without resorting to the printing press, and in the central bank's
ability to withstand government pressure to oblige it.

"A
surge in inflation expectations on the back of such a loss in confidence
would induce people to reduce deposits and cash holdings and pile into
real assets," Fels says. "The velocity of money and inflation
would rise and the government/central bank would have to keep printing
ever more money to finance government spending."

This
scenario is not totally fanciful and elements of it have indeed been
discussed by US Federal Reserve chairman Ben Bernanke.

In a
speech last month, Bernanke acknowledged that the Fed's support for
financial markets had resulted in rapid growth of the bank's balance
sheet. This had boosted the narrow definition of money supply -- bank
reserves and currency in circulation -- by more than 10 per cent in the
past year. However, the banks were leaving their excess reserves idle, in
most cases on deposit with the Fed, with little finding its way into
consumer or business hands. "At this point, with global economic
activity weak and commodity prices at low levels, we see little risk of
inflation in the near term," he said.

He foreshadowed
that the central bank would scale back its lending activities, including
support for commercial paper markets and investment in asset-backed
securities markets, as conditions improved. This would represent a
tightening of monetary policy.

The Wall Street Journal has
reported that Fed has gone cold on the idea of buying treasury bonds,
partly because, being long term, it would be harder for the Fed to unwind
its position.

However, the Fed is getting deeper into asset
financing, announcing last week that its investment in asset-backed
securities could rise to as much as $US1 trillion ($1.5 trillion).

The view in the gold market is that these are very early days in
the evolution of the public sector's management of the crisis.

In the 1930s, governments were hamstrung by the gold standard, which
obliged their central banks to redeem currency for gold at a fixed rate
for anyone who wanted it.

As Bernanke's own research into the
Depression has shown, countries were forced to raise rates to stop their
gold reserves coming under speculative attack. Nations were also limited
in their borrowing capacity by the need to preserve the gold link.

There was also a widespread view that cyclical downturns were a
necessary purgative of the excesses of capitalism, and that governments
should do nothing to interfere.

Partly stimulated by
Bernanke's research, both governments and central banks today are keen to
do whatever it takes to soften the economic blow.

They are
becoming the providers of liquidity to financial markets, the guarantors
of bank liabilities and, increasingly, the hospice for diseased banking
assets.

The iron independence in which central banks pursued
their inflation target while governments watched from the sidelines is
eroding as central banks join with treasuries in joint approaches to the
crisis.

As University of California's James Hamilton noted
last week, inflationary dangers lurk once treasury starts to see the
central bank as "the cookie jar" to cover pesky bills that
cannot be met by taxpayers or the public bond market.

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Received on Thu Feb 19 15:03:11 2009