Other factors could push gold price despite stronger U.S. dollar

Gold has tumbled sharply in recent days. The absence of any obvious inflationary pressure in the U.S., a firmer U.S. dollar and the market’s perception that the U.S. economy may be slipping into recession, have seriously eroded the atmosphere in the gold market just now.

Gold’s plunge to $430(us), from a peak of just over $500 in December, raises the question whether the bull market for gold has ended. My view is that it has not. I believe gold is experiencing a temporary down-draft because the principal factor driving gold higher since 1985, the U.S. dollar, has stopped declining. There are other factors, however, which will emerge over 1988 and 1989, and which have an excellent chance of pushing gold prices higher. The most important of these is inflation. Inflation on rise

It’s unfashionable to discuss inflation. Everyone “knows” there is no inflation at the moment; the big worry is deflation.

Figure 1 shows otherwise. It compares wholesale price inflation in the seven industrialized countries (known as the G-7) with the price of gold. The message is clear: we are currently experiencing the third big wave of inflation since 1970.

Clearly, inflation can decline and turn negative. It did so in the first and second quarters of 1976 and during the period from the second quarter of 1981 to the second quarter of 1985. But it is extremely unlikely to do so for any extended period of time in the immediate future. The reasons deal in part with how the G-7 inflation index is constructed.

Since the gold price is measured in U.S. dollars, a proper inflation comparison will have all inflation indices measured in U.S. dollars as well. So the G-7 inflation index is a weighted sum of domestic wholesale price indices, each adjusted for exchange-rate changes against the U.S. dollar. The inflation perspective is from the U.S. dollar; from this perspective prices in the G-7 area are rising rapidly. (Travel to Europe or Japan for a first-hand taste of this inflation.)

G-7 inflation rises as the U.S. dollar declines and/or as domestic inflation rates rise (measured in local currencies); G-7 inflation falls as the U.S. dollar rises and/or as domestic inflation rates decline.

Most of the G-7 inflation in recent years has been a direct result of the massive U.S. dollar decline. And as long as the dollar continues to decline, the G-7 index will keep rising. Dollar decline ending

But the U.S. dollar’s decline may have run its course. What now?

History is instructive. The U.S. dollar bottomed in July, 1973, and again in October, 1978. In each case gold first declined by about 20% in the space of a 6-week period, but then continued to rise because G-7 inflation did not peak for a full 24 months thereafter. Domestic inflation rates rose sharply, and this helped to push the G-7 index upwards.

Some feel we are currently in a 1973- and 1978-type situation. I do not think so, because one of the driving inflationary forces at that time was the sharp rise in the price of oil. It is unlikely that we will see a doubling and tripling of oil prices over the next two years. (But given the politics of the Mid-East, who can be sure?)

I do think, however, that the inflationary consequences of the massive decline in the U.S. dollar have been grossly underestimated. The United States is no longer a closed economy; foreign goods make up a significant proportion (12%) of U.S. consumption. The prices of these goods have to rise in order for the U.S trade deficit to decline. If the prices of imported goods do not rise, the trade balance will not improve and the dollar will renew its decline.

Given that the U.S. economy has little slack, import-competing firms will also be raising prices, and so on. The Federal Reserve Board is poised to counter these inflationary pressures, but a vigorous attack on inflation risks sending the U.S. economy into recession (or worse).

A recession in 1988, as opposed to an economic slowdown, is not likely unless the Fed makes a serious mistake. Indeed, the Fed has recently allowed that it has loosened monetary policy somewhat. Count therefore on somewhat higher U.S. inflation in 1988 and 1989. Money supply

But inflation abroad should also turn upward.

Massive central bank intervention in the foreign exchange markets has expanded domestic money supplies abroad — both the German and Japanese money supplies are rising sharply in local currency terms. Inflation rates are still low, but significantly higher than they were a year ago.

Figure 2 points to an explosion in G-7 money supplies. It charts the gold price against a proxy for real money supply in the G-7. (This proxy is the sum of M1 for the G-7 converted to U.S. dollars, divided by the G-7 inflation index.) The proxy is advanced eight quarters, so it serves as a leading indicator of the gold price.

Figure 2 suggests that the G-7 area is awash with money when that money is measured in U.S. dollars. Such a large U.S. dollar pool of money has been positive for financial markets (in U.S. dollar terms) and positive for the U.S. dollar price of gold. Debt and politics

Figures 1 and 2 show that gold rose in late 1982. This rise was not preceded by an upturn in inflation and accordingly came to an abrupt end.

The cause of this brief gold price rally was Mexico’s emerging debt problems. The International Monetary Fund met in Toronto in September, 1982. The discussion of this problem, and the expectation that the problem would lead to rapid inflation, caused gold to rise by $100 in early September. Just prior to then, in July, other financial problems (Penn Square) had caused gold to rise by $50.

The point is, international and domestic debt problems have in the past caused significant rises in the gold price. The situation is at least as precarious today as it was in 1982, and many feel it is worse. A debt-related blowup is not out of the question.

A similar argument holds for political events. History has shown gold to be linked to destabilizing political events. The one which stands out above others is the Soviet invasion of Afghanistan and the U.S.-Iran hostage crisis. This caused gold to peak over $800 in early 1980.

The point is that there are currently a number of sensitive problems — in South Africa, the Mid- East and elsewhere — which could re-emerge, or emerge as factors pushing gold prices upwards. Gold supply up

On gold supplies there is general agreement: supplies are rising. Yet even this should be kept in perspective.

Gold supplies totalled 1,967 tonnes in 1986, up 360 tonnes over that of 1985. But gold prices rose in 1986. Other factors were more important.

In 1987 gold supplies are likely to have totalled about 1,930 tonnes. The gold price rose in 1987; other factors were more important.

Over the next few years a lot more tonnage will appear, but bear in mind 100 tonnes is worth about $1.5 billion at current gold prices, or about what the Bank of Japan spends in one hectic day supporting the U.S. dollar. The market value of the New York Stock Exchange is around $2,500 billion. A miniscule shift in investor sentiment could easily absorb 200, 300 or 400 tonnes of gold.

Gold is cheap in yen and deutsche marks. Demand should therefore also continue to rise, particularly if advertisements promoting gold consumption begin to take effect.

This is not to say that supplies cannot suppress the price of gold. I am particularly concerned about the supply “bunching” which has been in evidence in recent weeks. With gold in a vulnerable phase — the U.S. dollar is not declining just now and domestic inflation rates have remained subdued — the price of gold will fall if six months of supply, say, are sold in the space of a few weeks. Gold loans and forward sales have this effect.

Barring such bunching of supply, gold supplies do not represent an insurmountable problem. I suspect that when gold hits a cyclical downturn, as it eventually will, it will be other factors that will cause it, and supply will be one of the factors exacerbating the steepness of the decline.

At this time,
a major cyclical downturn is not one of the most likely scenarios. The U.S. does not want the dollar to rally and kill the improving manufacturing climate, and the Fed does not want to trigger an economic recession. Accordingly, I will wait for higher inflation to lift gold out of its current depression later this year and in 1989. Martin Murenbeeld is president of M. Murenbeeld & Associates Inc. of Toronto.