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Positive Economic Commentary

What's Making Gold Glitter?
January 27, 2003

The London p.m. gold fix on Friday, January 24, was $366.00 an ounce - the highest price since January 2, 1997. Compared with a year ago, the dollar price of gold is up $86.80, or almost 31%. Why is gold starting to glitter? The most common answer is the answer for just about everything that might be rattling markets of all sorts these days - concern about an armed conflict in Iraq. Although Iraq may be playing a role in gold's recent price rise, I believe there is something more fundamental at work here - investors' fear of not getting an "honest return" on their funds. By "honest return," I am referring to a positive inflation-adjusted return on money market instruments such as 3-month bank paper. When investors cannot get an honest return on their short-term funds, they turn to other liquid assets that will, at least, preserve their purchasing power. Historically, gold has been one of these liquid assets.

In terms of U.S. dollars, investors can no longer get an honest return on their short-term funds. To wit, in December, 3-month LIBOR rates in dollar terms averaged about 1.38%. Yet the Consumer Price Index was up 2.38% versus December 2001. Therefore, the inflation-adjusted return on 3-month funds was minus 1.00%. But investors seeking an honest return on their funds are not restricted to buying only dollar-denominated money market instruments. They could purchase instruments denominated in euros or pounds sterling, for example. And, in fact, an honest return can be obtained in terms of these two currencies - 1.25% in pounds sterling and 0.55% in euros. But, as shown in Chart 1, the trend is not your friend for honest returns in these currencies. Although inflation-adjusted returns are still positive in terms of pounds sterling and euros, the magnitudes of those positive "real" returns are getting smaller.

What is the outlook for the trends of real returns in terms of dollars, pounds sterling and euros? The Fed has indicated that "deflation" will not occur on its watch. My interpretation of this is that the Fed is going to err on the side of tolerating more inflation before raising its target interest rate. And, if the current economic "soft patch" should persist into the first quarter, which I think it will, then the Fed might even opt to cut its target rate further. Unless inflation were to move lower by the same amount, the inflation-adjusted return on 3-month funds in dollar terms would move further into negative territory. Currently, both the UK and the Eurozone economies are encountering their own "soft patches." On July 9, a new president of the European Central Bank will take over. He most likely will be more sympathetic to cutting interest rates in an effort to crank up the pace of economic activity in the Eurozone if a recovery is not apparent by then. The Bank of England gets a new governor on June 30. He will be under pressure to cut rates if the UK economy is not showing stronger growth. In sum, expectations will be growing for declining central bank policy interest rates in the U.S., the UK, and the Eurozone in coming months. This argues for lower inflation-adjusted money market interest rates in terms of these three currencies. In other words, it is likely to become more difficult to get an honest return on your money in major capital markets. As I said at the beginning of this commentary, when investors cannot get an honest return on their money, they turn to other liquid assets that protect them from the ravages of inflation - gold being one of them.

In recent weeks, the dollar has tumbled in value in relation to the euro and the pound sterling (see Chart 2). If the dollar is depreciating against another currency and the dollar price of gold remains unchanged, then there are arbitrage opportunities to buy gold in dollars and sell it in the currency that is appreciating relative to the dollar, say euros. This will tend to drive up the dollar price of gold relative to the euro price of gold. We cannot say for sure whether the dollar price of gold will rise absolutely or the euro price of gold will fall absolutely. All we can say for sure is that their relative prices will change.

But what if, with the dollar depreciating against the pound and the euro, the price of gold is rising absolutely in terms of dollars, pounds sterling, and euros? That would be consistent with the notion that investors are becoming fearful of not being able to get an honest return on their money. And Chart 3 shows that the price of gold is rising not only in terms of dollar, but pounds and euros, too.

An acquaintance of mine, Clyde Harrison, a managing member of the Rogers Raw Materials Fund, says that fiat currencies do not float, they just sink at different rates. That gold is starting to glitter in terms of dollars, pounds, and euros seems to bear out what Clyde has said.

Paul Kasriel
Director of Economic Research

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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