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 INDEX  >  Gold bugs are right to fear inflation

    Wednesday, October 13, 2010   GEORGE ATHANASSAKOS


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George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario

Gold prices have been hitting new highs, defying all predictions of a price reversal. But oddly enough, the metal's rise is based on a view of the future that is directly opposed to what the bond market believes.

More than two years ago, in February, 2008, I wrote about the conflicting signals from the bond market and gold prices. At the time, I sided with gold. My views have not changed.

Just as in 2008, the markets for real assets, normally a good hedge against inflation, are now booming. Gold prices have appreciated at a rate not seen since the last big runup of inflation in the late 1970s and early 1980s. So have the prices of other commodities such as energy and food.

The rush to hard assets is a sign of growing worry that future inflation will erode the value of paper money.

But just as in 2008, the markets for financial assets, like bonds, appear little concerned about the likelihood of higher inflation in the future.

Bond prices have gone up while interest rates on long-term bonds have plunged. The bond market is saying that inflation, which dilutes the buying power of bond payments, will not be a problem down the road.

Just as in 2008, commodity and bond markets can't both be right. Something has to give. My money is on the side of the markets for real assets, like gold.

While there have been a number of economic and financial developments over the past decade favouring gold, the primary force behind its meteoric rise is investors' conviction that gold will act as a haven against a long-run increase in inflation and the related debasement in the value of the U.S. dollar.

The dramatic expansion since the early 2000s of M3, a broad measure of money supply in the United States that has been discontinued by U.S. monetary authorities but is still estimated by economists, has shaped this conviction.

M3 increased at an annual rate of about 8.5 per cent between 2002 and 2009. A similar increase in the 1967-to-1974 period led to U.S. inflation of about 9 per cent a year between 1974 and 1981. During that inflationary period, the U.S. dollar fell and gold prices rose. The G10 index of the exchange value of the U.S. dollar (an index comprising 10 currencies) fell from 100 in July 1974 to 84.6 in July, 1980, while gold soared from about $200 (U.S.) to $600 over the same period.

Just as in the 1970s, gold prices have been headed up and the U.S. dollar down. But it may not be that gold prices rise because the U.S. dollar is falling, as many commentators seem to suggest, but rather that both gold and the U.S. dollar are responding to an expected increase in long-run inflation, with gold reacting positively and the dollar negatively. If so, any possible inverse relationship between gold and the U.S. dollar is rather spurious.

Worries about inflation are not going to disappear any time soon. In my opinion, the crisis and the sharp recession of the past two years and the subsequent rescue packages around the globe did not provide the necessary catharsis that recessions need to bring to economies. They did nothing to change the underlying structure of the world economy.

Markets and economies around the world have become hooked on low interest rates and liquidity infusions. This is seen in the panicky reaction of financial markets to interest rate increases.

Every time interest rates seem to be headed upwards, financial markets collapse. Monetary authorities panic at this collapse and flood the markets with liquidity, which pushes down interest rates. But the longer this drags on, the sharper the effect on long-run inflation and the bigger the economic and financial fallout.

Short-term deflationary forces may appear within the next 12 months. In the long run, though, gold is acting as a haven against long-run inflationary forces in the U.S. and global markets and the adverse economic effect that rising inflation in the long run will have on financial assets. High and rising gold prices reflect this fear. They are not irrational, but a reasonable reaction to these unusual times.

© 2010 CNBC  Article Source
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