Between 1970 and 1980, the price of gold shot up from US$35 an ounce to $850, an increase of nearly 25 times. It then went downhill and bottomed out at $280 an ounce 20 years later.
The acceleration of the gold price since the start of the sub-prime crisis has attracted a lot of speculation. Many small-time speculators put their faith in the false belief that the gold price was a sure bet. For example, in Thailand they have often been told that the gold price was only ?400 per baht (15 grams) of gold in the old days.
For 25 years, the Bretton Woods system pegged the price of gold at $35 per troy ounce. The system collapsed in 1971 and gold prices started rocketing until the end of 1970s, the so-called Decade of the Great Inflation.
We may analyse the long-term trend and the cyclical behaviour of the gold price by tracing its path through the eight decades since the beginning of the Bretton Woods system in 1944, based on the simple concept called the "interest parity" condition. This condition can be stated as a very simple equation:
iG is the interest rate on gold, which is zero.
i is the interest on close substitute of gold. I suggest the weighted average of interest on Treasury bonds of various maturities to represent i.
dE is the expected depreciation of the US$ as compared with gold.
The real challenge is to determine the value of dE. A good starting point is to assume that the real price of gold is constant in the long run. Under this assumption, dE equals expected inflation rate (ðe), which suggests that people will choose gold when i < ðe (and vice versa), which will cause the gold price to go up (and down when I > ðe).
Under the Bretton Woods system, the real price of gold went lower as inflation accumulated. Therefore the gold price rose sharply after US president Richard Nixon announced the end of gold convertibility of the US dollar in 1971. The stagflation of 1974-75 sent the gold price skyrocketing because of (among other reasons):
- Negative real interest rate, ðe was high while i was low (to fight unemployment);
- Loss of confidence in the value of the US dollar.
As chairman of the US Federal Reserve in the 1980s, Paul Volcker kept interest rates high enough long enough to bring inflation expectations down. The downward trend of the gold price over the two decades that followed can be explained by the positive real interest rate over this period.
From 2000 to 2011, the gold price was on upward trend again. Initially that might have been due to the dot-com crisis, followed by a prolonged easing of the Fed monetary policy, which caused a bubble in housing. Meanwhile, there was a global imbalance that shook the confidence in the US dollar. A rapid rise in the oil price before the sub-prime crisis also brought anxiety over inflation. The combination of these factors was responsible for the rise in the gold price up to 2008.
The US response to the sub-prime crisis (near-zero interest rate and quantitative easing) sent the gold price sky-high again. After 2011, the US economy was on a moderate recovery path, so the Fed was preparing for an exit strategy. The European crisis was not so alarming, and China seemed to withstand the repercussions of the Western downturn well enough to influence the steady growth of the large part of the emerging economies. Inflation seemed to be contained, so the gold price stopped rising and tended to fluctuate downward.
The movement of the gold price in the next few years may be predicted under the following scenarios:
1. Economic recovery in the Western countries gets stronger, enough for policy-makers to turn their attention to pre-empting a new bout of inflation. The gold price will go down as interest rates will be higher than expected inflation.
2. The threat of inflation starts to appear while eased monetary policy is prolonged because of the weakness of the economy. The gold price will move up as inflation is expected to be higher than interest rates.
Rachain Chintayarangsan PhD is associate professor at the Graduate School of Development Economics, National Institute of Development Administration (NIDA). E-mail Rrachain@gmail.com.