A slightly off-center perspective on monetary problems.
As far as I know there is really only one respectable argument that inflation expectations are approaching dangerous levels in the US. We know that 5 year TIPS spreads are low, and we know that the near to medium term consensus inflation forecast is low. We know actual inflation is low and falling. But then there are those gold prices.
Iâ??ve never been convinced that the high gold prices were signaling US inflation fears. One problem is that gold prices are set in a global market, so itâ??s not clear why we should assume they are forecasting high inflation in the US, rather than the eurozone, Japan, India or China. India has generally been the worldâ??s largest buyer of gold. Furthermore, most other metals prices have also been soaring, presumably due to rising demand in the developing world.
First letâ??s look at the supply side of the equation. We canâ??t directly observe supply curves, only equilibrium points. But nonetheless the recent price and quantity data suggests that supply may be falling. We know that gold prices have soared in terms of all major currencies, and yet gold output continues to decline rapidly:
Note that production peaked at 2600 tons, and fell to 2260 tons in the latest year available (2008.) Iâ??ve read articles suggesting that most of the world has now been thoroughly explored, and it is felt that most of the major goldfields have already been discovered. Producers are having to concentrate on less high quality ores.
Set against that bleak supply picture, we have the following news from the FT about gold demand in China:
Gold imports into China have soared this year, turning the country, already the largest bullion miner, into a major overseas buyer for the first time in recent memory.
The surge, which comes as Chinese investors look for insurance against rising inflation and currency appreciation, puts Beijing on track to overtake India as the world's largest consumer of gold and a significant force in global gold prices.
"Investment is really driving demand for gold,"? said Cai Minggang, at the Beijing Precious Metals Exchange. "People don't have any better investment options. Look at the stock market, or the property market "â?? you could make huge losses there."?
Beijing has encouraged retail consumption, with an announcement in August of measures to promote and regulate the local gold market, including expanding the number of banks allowed to import bullion.
Shen Xiangrong, chairman of the Shanghai Gold Exchange, who disclosed the import numbers, said uncertainties about the Chinese and global economies, and inflationary expectations, had "made gold, as a hedging tool, very popular"?.
The rise in Chinese demand could further inflate gold prices. Bullion hit a nominal all-time high of $1,424.10 a troy ounce last month. But adjusted for inflation, prices are far from the 1980 peak of $2,300.
"The trend is undeniable "â?? gold demand in China is rising rapidly,"? said Walter de Wet, of Standard Bank in London.
. . .
Those Chinese consumption estimates are rather large when set against a world production total of 2260, and falling. I seem to recall someone pointing out that Asian gold demand couldnâ??t be the problem, because the totals were fairly stable. But that confuses shifts in demand with movements along a demand curve. When world output is falling, it is necessarily true that total quantity demand will also fall. If you confuse demand and quantity demanded, it will never look like higher demand is pushing up prices when output is declining. For instance, consider the following scenario:
1. The world supply of gold is shifting to the left, and is expected to continue doing so.
2. Chinese demand is rapidly shifting to the right, and is expected to continue shifting right as Chinese wealth rises dramatically.
3. Indian demand is shifting right, but much more slowly.
Hereâ??s what I would expect. Global gold prices would be expected to rise strongly over the next few decades. If markets are efficient and nominal interest rates are very low, the expected future rise should also raise current gold prices. The intertemporalarbitrage necessary to make this happen would be provided by gold speculators who buy up lots of gold, driving current prices much higher. Because Indian demand is increasing only modestly, yet remains the worldâ??s largest, the higher price causes India to slide up and to the left along their demand curve, to a higher price and a lower quantity demanded. People might wrongly assume that Indian demand had declined, whereas in fact Indian demand was still increasing (due to income growth) but the price was increasing so fast that quantity demanded declined.
The fact that Chinese quantity demanded increased rapidly despite a huge rise in gold prices suggests that the Chinese demand curve is moving to the right at a truly explosive rate. Indeed in this model it would be possible for future expected Chinese demand to explain 100% of the worldâ??s recent gold price rise, even if the current quantity demanded were falling slightly. Speculators might be holding gold stocks in readiness for future expected Chinese demand. But of course Chinese consumption (Qd) is rising fast despite the high prices.
The real price of gold is still much lower than in 1980, a time when China was not a factor in the world gold market, and also a time when lots of new gold fields were yet to be discovered. I can easily understand how savvy hedge fund managers could see the China boom as being very bullish for gold:
The surge in gold imports to China bodes well for some of the world's biggest hedge fund managers, including David Einhorn of Greenlight Capital and John Paulson of Paulson & Co, who have invested heavily in bullion, and top miners Barrick Gold of Canada, US-based Newmont Mining and AngloGold Ashanti of South Africa. [Also from the FT article.]
Again, I donâ??t doubt that there are individual investors fooled by news stories of massive monetary base increases and huge deficits, who think that high inflation is just around the corner. Not many average investors know that the same thing happened 15 years earlier in Japan, with no inflationary consequences. But I believe the best point estimate of the marketâ??s consensus inflation forecast comes from the CPI futures market, as well as the TIPS spreads in the T-bond market.
One interesting question is why Chinese inflation is rising sharply. Itâ??s clearly not due to any rise in US inflation; rather the most likely explanation is the Balassa-Samuelson effect. Iâ??ve been predicting a huge appreciation in the real value of the yuan for quite some time, and so far Iâ??ve been right. A recent article in The Economist pointed out the real yuan is up about 50% since 2005, with about half the increase being nominal appreciation and the rest representing higher inflation in China.
Update: Commenter David Pearson sent me the following information:
The World Gold Council recently published the latest issue of Gold Demand Trends for Q2 2010, which suggests demand for gold for the rest of 2010 will be underpinned by the following market forces:
Note that none of the major factors driving future gold demand is associated with inflation fears in the US. The report also indicated that investment demand has risen strongly in 2010, but this is consistent with my argument that higher future Chinese demand, coupled with slow growing supply, would lead speculators to buy gold in anticipation of future price increases.
Here is another way of thinking about the problem. Suppose that the Chinese yuan is expected to double in real terms over the next 25 years (which I think is quite likely.) Also suppose that gold prices in dollars are expected to rise at the risk free interest rate (on T-bonds.) In that case gold prices in yuan terms might be expected to show little change over the next 25 yearsâ??which would lead to a much higher quantity demand as China becomes much richer. That future expected Chinese demand (partly driven by the Balassa-Samuelson effect combined with Chinese exchange controls) could very easily be underpinning current investment demand in the US.
PS. The article above links to â??Gold Demand Trends,â? which shows a wealth of detailed information about the gold market. It seems gold ouput has risen a bit since the 2008 figures I got from Wikipedia. But that doesnâ??t mean the supply curve is increasing.
Tags:
24 Responses to â??About those high gold pricesâ?
Scott,
Not sure of your source. The World Gold Council produces supply and demand stats. They show supply â?? net of hedging â?? up around 15% in 2009 and another 8% in YTD 2010. Supply is also up excluding hedge reversals.
Keep in mind that supply net of hedging is the key metric as far as the impact on price is concerned. Miners began buying back forward sales in 2005, and it has continued until this year.
The boom in Chinese imports is concentrated in investment demand if the WGC figures on Jewelry are correct. Why would one hoard gold instead of currency as a store of wealth? There is only one reason, and that is to hedge against against a decline in the purchasing power of the currency. With Chinese inflation accelerating and real deposit rates negative, it is no wonder why the Chinese are choosing to hedge.
While quantity demanded is not demand, the biggest change in quantity demanded since the gold price started spiking â?? from sales to purchases â?? is by Central Banks. Clearly, they are purchasing more at higher prices, and this is an indication of a curve shift. There is only one reason for central banks to favor gold over dollars as a store of reserves, and that is uncertainty over the purchasing power of the dollar.
Yes, the gold price has been rising in other currencies as well. Perhaps that has something to do with the likely possibility that those countries (Japan and the Eurozone) might choose monetize high fiscal deficits on a long-term basis. In the case of the dollar-bloc countries (including China), the gold rise in local currency terms indicates a low probability of the country abandoning the dollar bloc with a maxi-reval.
Attached is the WGC link. Click on â??Gold Demand Trendsâ?, mid way down the page to see the latest (Q3) report.
http://www.gold.org/investment/statistics/demand_and_supply_statistics/
Balasa-Samuelson, catching up. Two sectors, productive-improductive. Yes, quite possible indeed. But, I can´t imagine why the chinese authority have any interest in openning the gold market for everybody.
Itâ??s not gold prices that worry me; itâ??s oil prices. Youâ??d think the world economy was kicking ass if you just looked at oil.
Superb essay by Scott Sumnerâ??precisely my conclusion after reviewing world gold markets a few months back.
If Chindia demand for gold continues, we may yet see record gold pricesâ??and it has little to do with US monetary policy.
The US is a smaller player in world gold markets.
Scott, I donâ??t get this line:
â??Also suppose that gold prices in dollars are expected to rise at the risk free interest rate (on T-bonds.) â?
Whatâ??s the basis of that assumption? How is this consistent with the earlier part of the post that is explaining a big *rise* in gold prices?
David, Thanks, I added an update that reflected that information. A few comments:
1. The link you provide mentions 4 factors driving future gold demand higher. None are related to inflation fears in the US.
Read Full Article »