I remember it clearly. Every gold investor’s dream came true at the beginning of 2022. If you’d made a checklist of things that are good for the gold price, every box would’ve been ticked back then. And yet, the gold price fell this year…
Today, we look into one possible explanation for why. And it’s quite simple, really.
Inflation got so far out of hand that even blind central bankers could no longer ignore it. Indeed, double-digit inflation forced them to take action. And that rapid tightening was bad for gold.
My point is that there is a ‘Goldilocks Zone’ for the gold price. High inflation, but not high enough to make central bankers panic.
Low interest rates and loose monetary policy, but not low and loose enough that monetary policy has to be tightened by an order of magnitude just to get back to a neutral stance, let alone slay inflation that’s out of the box.
Structural government deficits, but not enough to trigger a debt crisis.
There are several other factors, which must be ‘just right’, but I’m sure you get the idea. If gold is an antidote to irresponsible monetary policy, then macroeconomic conditions, which are so bad that they force central bankers to get their act together, is not good for the gold price. The porridge can be too cold and too hot.
In early 2020 and the beginning of 2022, we were in this Goldilocks Zone, although for completely different reasons.
During the onset of the pandemic, central banks and governments went mad on interventions, setting the scene for a rally in the gold price.
Into 2022, inflation hit, and monetary policymakers simply pretended it was transitory, setting the scene for a rally in the gold price because they weren’t going to tighten policy despite the inflation.
But since early 2022, things have changed radically. There has been a panic from central bankers around the world to get inflation under control after all.
They were so embarrassed by their negligent ‘transitory’ episode that they tried to make up for it with rapid tightening. That is why gold fell, despite the seemingly good conditions for it continuing (inflation and low interest rates).
The question now is whether we’re headed back to the Goldilocks Zone for gold. Will inflation fall, but not all the way below 2%, and will central banks slow their tightening to end up with interest rates still on the low side?
I think that’s the likely outcome. But I want to point out some very awkward inflation maths that I think will cause your stomach to drop more than a ride at Dreamworld…
Imagine the world economy is suddenly hit with a pandemic’s worth of supply chain disruption due to lockdowns, a green energy escapade, sanctions on Russia, huge quantitative easing from central banks, and vast government spending programs, all at the same time.
Unlikely, I know, but bear with me.
In other words, we get supply chain delays, shortages, cost spikes, and a wall of money that swamps the economy.
The result is a spike in prices, which shows up in statistics as double-digit inflation.
Fine. But what happens next?
Do prices continue to go up?
Let’s say they do rise to even less affordable levels. But not as fast as over the past year and a half.
What do inflation statistics look like in that scenario?
Inflation would fall but remain positive. Because prices would be rising slower than they were before.
This is an important point. Prices would still be getting less and less affordable. From awfully high prices to terribly high prices — the problem of high prices would be getting even worse.
But inflation statistics would go down as the pace of price increases slows, cheering the stock market and encouraging central bankers to pat each other on the back. All while unaffordable prices continue to go up and up…
But are prices really going to continue to go up?
Consider what happens to inflation data if the answer is ‘no’. If prices soared in 2021 and 2022 because of all the forces mentioned earlier, and then they remain very high, but stop going up. What would inflation statistics look like in 2023?
They’d be 0% inflation. Because prices would’ve stopped rising.
But prices would still be high. Painfully high, in some cases. Enough to cause European factories to shut down, to keep homes uncomfortably cold, and to make a great deal of economic activity unviable.
But inflation would be zero. Because prices stopped going up.
Ironically, in such a scenario, central bankers would not be congratulating themselves for having solved the problem of inflation. No, they’d panic about a lack of inflation. Their mandate, after all, is to keep inflation at around 2%, not 0%.
So, to central bankers, painfully high prices would not be high enough if they stopped rising.
Can’t pay your energy bill? Well, the central bank still needs to generate 2% inflation somehow…
Is food unaffordable today? Well, food prices need to keep going up, but only by 2%…
Are your wages falling behind prices after 2021 and 2022? Well, prices must keep rising, but only by 2% a year…
My point is that high prices are not inflation. Only rising prices are. And, for the inflation problem to persist, prices must continue to rise.
If prices stop going up, inflation falls below the central banks’ target. Even if those prices remain unaffordable.
But I’m not convinced that rising or stable high prices are plausible given the effect on the economy of high prices so far.
It’s far more likely that many prices will come back down again as a recession hit because of high prices. This means negative inflation or deflation.
Now, you might think that falling prices are just what we need, given people can’t afford things after a year of double-digit inflation in the US and Europe.
But the irony is that central banks fear deflation above all else. That’s because it makes debt harder to repay. And central bankers encourage economic growth via borrowing.
But never mind that. Follow my line of thinking on inflation to its logical conclusion.
If prices are high and are threatening to come back down to affordable levels, meaning deflation, what are central bankers going to do about it?
Their mandate is 2% inflation, not affordable prices, and certainly not deflation.
Their mandate is to bring 2% inflation to bear on the dangerously high and unaffordable prices we have today.
This is a bizarre situation where central bankers don’t focus on how expensive something is, but on making it 2% more expensive each year, even if it’s already severely unaffordable due to past inflation.
Allowing prices to fall back down to manageable levels would mean the dreaded deflation takes hold. And that must be avoided at all costs!
The conclusion is simple. Central banks are going to try and cause unaffordable prices to get even less affordable. Just not quite as quickly as during the past two years.
If they succeed, painfully high prices will be even more expensive next year. But, as long as the increase is only around 2%, that’s what success looks like…
In the coming months, I want you to keep several things in mind to avoid being misled by falling inflation statistics…
Firstly, they are not good news. Prices are still rising. Given how high they are, 2% inflation or even 0% inflation is still bad news.
Just because prices are getting unaffordable at a slower pace doesn’t mean they aren’t reaching ever more absurd levels, causing real economic problems.
If you’re waiting for prices to come back down to more affordable levels, you might be waiting for a long time. The central banks’ mandates are 2% inflation, not bringing prices back down to the level you can afford.
And last but not least, don’t confuse high prices with inflation (rising prices). It could be an expensive mistake to make.
Until next time,
Editor, The Daily Reckoning Australia Weekend