Foreign central banks have been withdrawing their gold from the Fed. According to the Federal Reserve’s most recent update, a whopping 224 tons of gold have been withdrawn from its vaults since the beginning of 2014. (Source: U.S. Federal Reserve, last accessed September 9, 2015.)
Sure, gold hasn’t looked so shiny in the past few years. But to understand why central banks want their physical metal back, and where gold prices are going next, let’s take a look at what has been going on in the economy.
Here’s Why Gold Prices Could Be Going Higher
It all started with money printing. You see, expansionary monetary policy has been used to deal with financial crisis by countries all over the world. Take the U.S. as an example; since the Great Recession hit our economy in 2008, the Federal Reserve has increased money supply by 67%, or more than $5.0 trillion!
The European Central Bank (ECB) has joined the game too, starting its 1.1 trillion euro quantitative easing program earlier this year. Most recently, ECB president Mario Draghi announced a revamp of its QE program. The Governing Council has raised the purchase limit of any given bond from 25% to 33%. The ECB also lowered its inflation forecast and kept interest rates unchanged at record lows.
So, what would be the effect of these record loose monetary policies?
Well, first of all, when trillions of dollars are poured into the asset markets, asset prices will shoot up. That’s exactly what happened. Both the stock market and the bond market soared to all-time highs.
The asset market bubbles won’t last forever. As we have witnessed recently, markets have crashed around the world. Moreover, when the money flows out of the asset markets and enters the real economy, we’ll get massive inflation.
The idea is simple: when there is more money chasing the same basket of goods, each good in the basket is going to command a higher price. The reason we don’t see much inflation right now is because most of the money was pumped directly to the asset market.
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Another effect is that the growth we see might be a result of these artificially low interest rates. You see, when borrowing money is cheap, there will be a lot of financing activity. Indeed, over the past several years, businesses in the U.S. were able to fund their operations and expansions at record low interest rates.
This raises the question of whether the growth we see has been artificial as a result of the low interest rates, and how much of that growth will remain once interest rates resume to normality.
I’m sure that as an investor, you know that risk management is quite important. With the world economy being what it is, equity valuations are still high and massive inflation looming in the distance. I don’t think you need me to tell you how gold will play into all this.
What is more interesting now is that we are seeing central banks turning to gold as well. Since 2010, world central banks have remained net buyers of gold. (Source: World Gold Council, last accessed September 9, 2015.)
The idea is, under today’s fiat money system, money can be printed as much as the central banks want. Other than a country’s economy, there is really not much that’s backing up the paper currency. And the economy hasn’t been doing that well around the world. That is why central banks started hoarding gold.
Unlike paper money, gold cannot be created out of thin air. Although we are no longer under the gold standard anymore, having gold reserves still gives a country’s central bank and its currency credibility.
For example, China recently disclosed that it had increased its gold reserves by 57% to 1,658 tons. Greece, which had no money to pay back its debt to the ECB, did not sell a single ounce of its 112.5 tons of gold during these hard times. Despite this, Greece turned out to be staying in the eurozone, and its gold reserves would give the country some credibility if it decides to go back to the drachma.
Gold as a Hedge, for Investors and Central Banks
Foreign central banks withdrawing gold from the Federal Reserve reflects the same theme. People and central banks want the physical metal as a hedge against financial crisis and monetary crisis. Gold has helped investors preserving their wealth for centuries. And this could be another one of its shiny moments.