Today’s Gold Price

Since the September 2011 decline in the price of gold from $1900 to $1050, gold watchers continue to suffer from post-traumatic gold decline syndrome, PTGDS.  If the POG can fall from $1900 to $1050, it can just as easily fall from today’s $1240 to $900 or lower, or so goes the thinking.  During the decline from $1900, many predicted a POG below $800.

There is a huge difference between the POG decline from $1900 and prediction of a similar, new decline from $1240.  The decline from $1900 was not deflationary and bottomed out in July 2015 at $1050.  This was slightly below the intersection of the spot and optimum POG at $1100.  Today’s POG at $1250 is 33% below the $1900 peak.  A similar 33% decline from $1250 would cause acute deflationary market stress.  Its effect would be similar to Greenspan’s 1997-2001 deflation when gold fell from $400 in January 1996 to $250 in January 2001.  That deflation caused the Asian crisis and led to the tech boom crash.

Inflation and deflation are not mysterious monetary phenomena that occur for reasons beyond anybody’s control.  They are the result of central bank policy.  Venezuela, Argentina, and Turkey are experiencing inflation because their central banks are supplying more currency than is demanded. To end their inflation, they need only extinguish excess currency supply.  The POG acts as a monetary standard that references the supply of currency that economic actors demand. 

Theoretically, the Fed can obtain any POG it desires by adjusting base money supply.  Grasping this concept goes a long way in understanding what determines the POG.  If the Fed wants a $900 POG all it need do is make the market aware that it will extinguish base money supply until gold is at $900.  If the Fed wants to return to a gold standard and stable money at today’s optimum POG of $1270, it need only let the market know that it will adjust base money supply as necessary to make that happen.  The $1.8 trillion of excess reserves vastly complicates the Fed’s ability to match base money supply with demand.  The Fed needs to normalize its balance sheet by extinguishing excess reserves before it can regain direct control between base money supply and demand.

Any apparent trend in a new decline in the POG leads to differing analysis from the various gold camps.  Supply-siders understand that fiscal events such as tax policy, regulatory changes, growth in government, trade wars, hot wars, and geopolitical concerns affect dollar demand which the POG then reflects.  Excess reserves and IOR have complicated this analysis.  Failure to understand their effect has led some supply-siders to give up on gold.  They deign that it is a new world and gold has lost its monetary signal.  Nothing could be further from the truth.  

The gold industry resorts to the traditional canard of gold supply and demand.  Gold demand decreases for whatever reason, so the POG falls.  This analysis neglects gold’s unique properties and its stock to flow ratio that separates gold from all other commodities and negates supply and demand as a determinant in the POG.

Demand-side currency manipulators ignore gold and react in glee to declines in the POG because it justifies their belief that gold is indeed Keynes’ barbarous relic.  They ignore the gold signal and are clueless about the monetary events that occur as a result of their policies.

A common belief is that unspecified agents manipulate the futures market and drive the POG lower for nefarious reasons.  Selling large blocks of gold contracts can temporarily manipulate the POG, but they net out and do not affect the long-term trend in the POG.  The total stock of gold—virtually the production of all the gold in history—is vast in comparison with new supply.  It is not possible to manipulate new supply and affect the total stock which is a primary variable that determines the POG.

The supply of base money relative to its demand determines the POG.  Base money is cash and reserves.  The Fed has 100% control of the supply of base money.  The dollar is a global currency with estimates that more than half of the dollars in circulation are held outside the U.S.  The Fed accurately tracks base money supply down to the dollar, but there is no method to calculate dollar demand.

It is possible to recognize changes in dollar demand relative to supply by observing the POG.  This is the gold signal.  There is an optimum POG where debtors and creditors are in balance.  Observing the spot POG in relation to the optimum POG foreshadows whether the dollar is losing, gaining, or stable in value.  On a gold standard, the spot and optimum POG are the same.  To maintain a gold standard the currency manager (the Fed) would adjust the supply of dollars to maintain a fixed parity price with gold.

On our fiat standard, the Fed ignores dollar demand and adjusts dollar supply based on its selected academic theory du jour and hindsight data.  Gold signals the Fed’s monetary error.

Why has the spot POG fallen below the optimum POG of $1270?

One possibility is that with IOR increasing with each funds rate hike and the yield curve flattening, banks find it more advantageous to earn free Fed interest from reserves than to lend.  With more reserves being held as excess, supply decreases relative to demand and the POG will fall.  The POG is now $30 below optimum.  An extended decline in the POG will be deflationary.  A new deflation, if it gets there, will cause market turmoil, especially in emerging markets.  

A second possibility is that a declining POG could indicate stress in the global financial system.  This is what occurred during the onset of the 2008 financial crisis.  The dollar’s function as a safe haven caused an increase in dollar demand.  Without an adjustment to dollar supply, the POG fell from $1000 to $700.  Gold then began the climb to $1900 with the onset of QE. 

Thirdly, the market could be getting the POG wrong based on the belief that the Fed is tightening.  As long as excess reserves exist, the Fed has no direct ability to tighten the supply of base money relative to demand.  Warren Buffett has made a very lucrative career profiting when the market gets it wrong.  The POG fell during the initial Fed funds rate hikes that began in 2015 but has always corrected back. 

Regardless of the reason for the current fall in the POG, the history of fiat money is that it declines in value.  A rising POG will reflect this over the long-term.

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