As gold prices continue to decay, many suspect an interest rate hike from the Federal Reserve will suppress gold price forecasts. To reach a decision, the Fed will consider a range of economic indicators that, according to Nobel laureate Paul Krugman, suggest a continuance of low interest rates.
Whether or not the Fed will raise rates is a hotly disputed topic in financial circles. Just turn on Bloomberg or CNBC and a pair of talking heads will be squabbling over Janet Yellen’s latest speech, eagerly dissecting her state of mind. To be blunt, they rarely say anything worth listening to.
The real debate over interest rates happens in the obscure, jargon-filled world of economics. If that last sentence gave you a sudden urge to click off the page, or take a nap, then I apologize. But bear with me, because interest rates are incredibly important.
Rising interest rates would affect virtually every asset on the planet, directly or indirectly, and all investors should understand their implications.
What Krugman’s Wrong About
Conventional wisdom suggests rising interest rates will further deflate gold prices. Since 2011, the yellow metal has lost 42% of its value, lending credibility to that argument. Is it true? Will higher interest rates lead to gold rout?
Before we get to that question, we should consider the arguments for and against a rate hike. Paul Krugman believes those in favour of a rate hike are “conservatives whose doctrine tells them that fiat money will turn us into Zimbabwe any day now.” (Source: The New York Times, August 24, 2015.)
Krugman’s argument against raising interest rates is quite simple: the economy isn’t healthy enough yet. Wages are barely growing, inflation is non-existent, and unemployment is still above normal levels. He sees monetary stimulus as a necessary antidote to these conditions.
Rock bottom interest rates are meant to increase borrowing and spending. People could buy cars and homes for lower monthly payments, while companies would find it cheaper to invest in new equipment and land. A stock market boom would funnel cash to firms that create value and jobs.
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The plan only half worked. Stocks recovered tremendously, and some of it trickled down into job creation. But the rest remained stuck. Everyone (except Wall Street) had become so cautious that they didn’t want to spend, much less borrow money.
The United States fell into a conundrum that economists call the liquidity trap.
Gold Fears Rise On Anticipation of Interest Rate Hike
Few public intellectuals talk about the liquidity trap as much as Krugman. The guy is an expert, having written several books on Japan’s liquidity trap in the 1990s and 2000s.
He says that printing money and keeping interest rates low doesn’t really work in a liquidity trap, but it can have a useful placebo effect.
“Haven’t I been arguing that monetary policy is ineffective in a liquidity trap?” asks Krugman. “The brief answer is that current policy is ineffective, but that you can still get traction if you can change investors’ beliefs about expected future monetary policy.” [my emphasis]. (Source: The New York Times, April 11, 2013.)
Let that sink in. A central bank can affect what investors do today by changing their expectations of tomorrow. And that’s precisely why I think raising interest rates is so desperately needed. Because seven years into monetary stimulus, we’ve lost all traction.
Everyone is so accustomed to a low-rate environment that another few months of the same thing won’t do any good. At this point, the Fed should inject a sense of urgency into markets.
A small bump in interest rates, perhaps a 0.1% increase, would cause investors to think another rate hike is on the horizon. The concept would no longer be abstract, and there would be a clamour to secure loans while rates remained low.
Interest Rates and Gold Prices
Gold is a safe haven asset; a protective measure against economic chaos. But lately investors have preferred to hedge using Treasuries. Gold prices have depreciated against Treasury yields since late 2012.
Chart courtesy of www.StockCharts.com
The premium on gold is usually driven by a mistrust of the financial system. But we’re on the tail end of a bull market driven by—you guessed it—monetary stimulus.
Raising interest rates will be a good thing for the U.S. economy, giving companies and people a reason to borrow and spend before rates get even higher. Yet there’s no denying the immediate shock it will provide to financial markets.
Growth on the Dow Jones index is perfectly correlated with growth in the U.S. monetary base, showing that we all trade on a credit-fueled market.
Of course, the rate hike will burst that bubble. Financial markets are fickle and prone to panic —we should expect them to overreact to a normalization of monetary policy. The panic will send some investors in search of safety, and that’s where gold comes in.
Investors take special comfort in owning hard assets. Their usefulness doesn’t depend on the Federal Reserve or the U.S. economy; they are real and tangible. Even when economic fundamentals improve, and investors realize the market will survive normal interest rates, gold will have regained its power as a safe haven asset.