Gold Investing: The Case for Higher Gold Prices in 3 Charts

Gold InvestingDespite weak gold prices, excess money printed by the world’s central banks could ignite inflation, driving investors to safe haven assets. Policymakers have been using monetary policy as a form of stimulus in recent years, building a house of cards with nothing but paper money.

If that paper house collapses, disaster would inevitably follow. After 2008, the Federal Reserve undertook a massive operation to buy low-quality assets off the balance sheets of troubled banks. They did it to stabilize a volatile financial sector. But how did they pay for it? Oh right, they fired up the printing press.

And the United States wasn’t the only one. Central banks everywhere began to adopt the so-called “dual mandate”—instead of simply guarding against inflation, they would also aim to reduce unemployment. This was a noticeable shift away from the banks’ singular focus on keeping inflation at bay. But some argued that in the absence of fiscal stimulus, any and all measures were acceptable.

Buying Toxic Assets

From August 2007 to July 2015, the Federal Reserve’s balance sheet grew from $870.26 billion in assets to $4.5 trillion. (Source: Federal Reserve Board, July 13, 2015.) The bulk of these purchases happened during the quantitative easing program from 2008 to 2014. The Fed went from being a lender of last resort to a buyer of last resort.

However, this wasn’t a bad idea at the time. After Congress approved a bailout package for Wall Street, there wasn’t much help on the fiscal policy side. And although the banks were able to recapitalize and stay above water, investors still worried that they carried toxic assets. The Federal Reserve put a floor on the crash by unloading those assets from banks’ balance sheets.

As a result, markets grew optimistic and poured money back into the stock market. Just look at the relationship between the money supply and the Dow Jones Industrial Average. See anything suspicious?

Money Supply and Dow Jones Industrial Average Chart

Investors Fled Commodities

Gold prices started to plummet when investors realized this was a long-term strategy. The Federal Reserve was simply determined to prop up the market. The precious metal has lost nearly 40% in value since its high in mid 2011.

Gold - Spot Price Chart

In addition to buying a ton of useless assets from the big banks, the Fed also maintained rock bottom interest rates. The move was meant to create easier lending conditions. If the cost of borrowing was virtually nothing, banks could afford to make loans to companies and people. Once the companies and people spent the money, jobs would be created to meet the new demand, and economic growth would pick up.

Unfortunately, we were recovering from a debt-fueled financial crash, so naturally people were drowning in debt. They were trying to pay their loans off, not take more of them!

The Tipping Point

It’s likely that aggressive maneuvers by the Federal Reserve were necessary to prevent a deeper recession. But it’s also likely that the central bank’s attempt to create new growth was utterly useless. Luckily, they managed to avoid a sudden spike in inflation because of what economists call an “output gap.”

Imagine if all the equipment, factories, and human capital in the country were being used right now—that’s the potential output of the United States. When the country is using less than all its resources, it falls short of its potential output, hence the “gap.” (Source: IMF Finance & Development, September, 2013.)

If central banks print money when there’s an output gap, inflation isn’t really a concern.

Real Potential Gross Product Chart

The red line in the chart shows how the U.S. economy actually performed over the last few years. As you can see, a lot of resources wasted away in the aftermath of the crisis. We didn’t see much inflation in those years because of the recession, but look at how the gap has closed since 2010.

As we get closer to matching potential gross domestic product (GDP), inflation will start to emerge. It’s already happening. The Consumer Price Index registered a 0.4% increase during May 2015. If we estimate that the CPI continues to grow at 0.4%, we’re looking at five percent inflation over 12 months. (Source: BLS CPI Report, May, 2015.)

To recap, the Fed has been increasing the money supply to prop up the stock market. When they convinced enough investors that a stock market rally reflected an actual economic recovery, gold prices fell. But all that is changing.

The Federal Reserve has indicated that interest rates will rise later this year. They’re trying to let markets stand on their own two feet. But as soon as investors understand how cosmetic the last few years have been, they’ll begin to panic, making prices skyrocket for safe haven assets like gold.

Investors: This Could Send Gold Prices Soaring in 2015