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Economic uncertainty is increasing: How gold relates to inflation

Economic uncertainty is increasing: How gold relates to inflation

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by Ed Lomas

Mining the West Contributor

The common definition of inflation is “too many dollars chasing too few goods,” which results in dollars, or some other currency, losing value as prices increase on practically everything.

Inflation generally results in a higher gold price, because gold has the reputation of holding its value during economic turmoil, so people in countries undergoing inflation may buy more gold as the local currency loses its value. Economic problems in a few countries will generally not affect the global gold price in U.S. dollars, though.

Conventional wisdom is that holding gold is a hedge against inflation, but a 2020 study by Campbell Harvey of Duke University disputes this, claiming that gold price and inflation are poorly linked.

However, that is an American long-term view of global economics. The U.S. inflation rate has been low since the early-1980s, which has contributed to the dollar’s stability. If the U.S. dollar were to lose value through excessive inflation, a higher gold price would be more of a reflection on the declining value of the dollar than on the increasing value of gold.

Back in the late ’70s and early ’80s, when inflation in the USA was at its worst in recent history, wage increases hit 10% a year while banks were paying 16% interest on CDs. By 1981, interest rates on new car loans and home mortgages were around 17%. A $2,700 mortgage in 1981 would have been only $870 per month at today’s interest rate, and so fewer people could afford to buy a house.

All that seems unlikely these days, with banks now paying interest to depositors in fractions of a percent and inflation averaging less than 2% over the past five years. But when the dollars in circulation increase more rapidly than goods production, prices increase rapidly and people spend their money as soon as they can, before it loses value.

In high inflation countries like Argentina and Iran, people recognize gold as vastly more stable than their local currency. These countries have annual inflation rates around 50%, and their citizens deal with shortages while their governments dole out money to them to maintain political support and quell dissent.

The USA has not seen inflation above 50% since the late 1700s, and few expect anything like that in the near future, but our financial markets concede that inflation will increase in the near future due to recent high levels of government spending.

The federal government’s $4,900 billion bi-partisan COVID relief spending in 2020 has already increased the money supply, but the new administration’s $6,000 billion proposed development programs will further inflate the money supply unless there are corresponding tax increases. Proposed tax increases limited to high wage earners and corporations will only raise about $4,000 billion in additional revenue spread over 10 years, according to four independent studies, so the money supply will increase even more through the coming year or two.

This leads to more dollars without more goods, which returns to the classic definition of inflation. In April, consumer price increases rose the most in 10 years, and we have seen a boom in real estate, as well as steep price increases in various goods, such as lumber and gasoline. We have also seen sporadic shortages of random items from toilet paper to cat food, and although consumers have been told that these shortages are caused by panic buying and supply chain disruption, the pandemic is still not over, and no one knows what its economic aftereffects will be.

The Secretary of the Treasury recently assured the country that inflation will not be excessive, as has the Chairman of the Fed (our Federal Reserve, the central bank). Wall Street is not as optimistic. An executive who manages a $100 billion stock portfolio for a major investment firm described the fed’s mandate as “very inflation friendly,” citing households flush with cash, record levels of government spending, companies struggling for inventory, and high commodity prices.

During 2020, our national debt increased to 129% of the economy (GDP), and the new administration’s proposed spending during its first 100 days could increase our national debt an additional 20%. Prior to 2013, the national debt had not exceeded 100% since 1945. However, no one knows how much additional social spending and development spending the administration will propose in the coming months and how, or if, that spending will be financed and what all that will eventually do to the national debt.

At the least, this means that economic uncertainty is increasing, which is another trigger for inflation, and a higher gold price. While the federal government’s plans to increase spending may not result in Argentina’s inflation level, the economic hard times of the 1970s are within the realm of possibility.

In 1971, the U.S. abandoned the gold standard, meaning that dollars were no longer backed by gold. In 1973, inflation was kindled by OPEC’s oil embargo. The gold price subsequently rose from $125 per ounce in 1976 to $850 per ounce at the start of 1980. In 1979 dollars, $850 per ounce is equivalent to $3,000 in today’s dollars, so today’s gold price is still well below an all-time high in “real” dollars adjusted for purchasing power.

However, peaks based on speculation do not last, and by 1982, gold was trading at less than $330 per ounce. At that time, mortgage rates were still over 16% because the fed kept interest rates high to control inflation. Gold became less attractive, though, because the inflation rate had dropped from over 12% to 4%, and though the U.S. was in recession, the economic outlook improved because the fed’s harsh anti-inflation measure of keeping interest rates high was working.

What this all means for the price of gold and for a gold mining-based community like Elko is anyone’s guess. Public behavior is much more volatile now than it was then, since behavior can now go viral over the internet, as the country experienced with consumer hoarding in early 2020 and again last summer in the sudden widespread protests for the BLM movement. Viral behavior could contribute to another price spike in gold, and its current price level, hovering around $2,000 per ounce, may be easily exceeded anyway if inflation takes hold.

Bullion and coin promoters may stress simple supply-and-demand effects to predict a looming gold shortage as justification for increased gold prices, but that relationship is more complicated than the simple diagrams in economics texts. Gold supply is slow to increase to meet demand, and demand is more volatile than supply. However, a gold shortage is not likely in the U.S. because increased prices caused by inflation would be primarily a dollar-based demand, and the country’s gold usage is only about 4% of the global supply.

Another factor is how gold mining companies will react to inflation-driven gold price increases.

During the last major run up in the gold price from 2010-2013, gold mining companies did not expect the gold price to drop like it did in 1980, and they took on debt to purchase existing operations elsewhere in the world. That didn’t work out very well for them after the gold price fell by $600 per ounce in 2013, and companies were forced to sell mines to reduce their debt. Perhaps this time they will concentrate more on local expansions and less on foreign acquisitions. Expanding local mining operations would benefit Elko’s local economy, and so Elko may again weather the coming economic situation better than the rest of the country.

But higher gold prices may not benefit Elko this time as much as it has in the past, since this mining boom may be offset by high inflation. If the fed again raises interest rates to quell inflation, which it can do without Congress’ approval, the gold price could rapidly drop to below its production cost, as it did in 1982.

So the American economy, shaken by the costs of the COVID-19 pandemic and government spending proposals, will probably result in another bout of inflation, but people who live around the gold mining industry may avoid some of the turmoil better than people in other parts of the country. A lot of this depends on future actions of both the Biden Administration.

Everyone, regardless of income, bears the burden of inflation in higher prices and eroding value in savings, and since the administration may propose yet more deficit spending, we will not know for a year or two how this will all turn out. 

Ed Lomas of Elko has a degree in mining engineering from the University of Idaho and an MBA from Harvard University. He has worked as a mine and plant engineer, underground mine superintendent, vice president of operations, and in strategic planning and business analysis.

Ed Lomas of Elko has a degree in mining engineering from the University of Idaho and an MBA from Harvard University. He has worked as a mine and plant engineer, underground mine superintendent, vice president of operations, and in strategic planning and business analysis.

In 1979 dollars, $850 per ounce is equivalent to $3,000 in today’s dollars, so today’s gold price is still well below an all-time high in “real” dollars adjusted for purchasing power.


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