Monetary policy is the policy adopted by a central bank of a country that controls interest rates, often targeting inflation to ensure price stability and trust in the currency.
Periods of growth in the economy are usually supportive of technology, long term savings and jewellery demand, which in turn boosts the price of gold. This is particularly true in developing economies, where gold is used as a luxury item and a means of wealth preservation.
Economic expansion is tied closely with interest rates and inflation.
An interest rate is how much interest is paid by the borrowers of the money.
Inflation is the increase in prices of goods and services over time. It is also known as the cost of money, or cost of borrowing.
Rising Rates and Gold
When interest rates rise, it usually signals there is an increase of economic confidence. Businesses expand and the population with disposable income spend more increasing demand. Confidence in the future increases. Therefore, citizens feel more comfortable taking out loans and mortgages confident they will have the ability pay the loan back. This is usually dependent on the personal outlook on their future income and wealth prospects.
During times like this, there is less of a demand for safe haven investments (like gold) and the domestic currency is strengthened which can cause the demand of gold to decrease for investment purposes. On the other hand, more wealth and higher disposable income can also lead to more demand for gold for jewellery and industrial purposes.
As the demand for credit increases banks can charge more for loans in the form of higher interest rates. Financial institutions can make higher returns on their loans when the cost of borrowing is higher. However, what really drives the increases in rates is the central bank, who monitor aggregate demand in the economy and the rate of economic growth as well as inflation.
If the central bank thinks the economy is overheating, or in danger of overheating then they will raise interest rates in an attempt to cool demand. This is because in the last four decades targeting small increases in inflation has been the dominant policy philosophy. This goal is sometimes called price-stability. Central banks want to maintain price stability to ensure a degree of certainty in the general level prices which is crucial for a successful economy. Too much inflation can destroy a currency and creates huge problems for economies and societies. Too much deflation means that spending is delayed in anticipation of falling prices which can create a self-fulfilling feedback loop that slows the economy.
Changing Rates and Gold
Research shows that interest rates have a greater impact on the price of Gold when there is a shift of stance on monetary policy – for example, from neutral to tightening, or vice versa.
When interest rates fall or remain unchanged, it can be signal that there is a lack of confidence in the economy and growth is stalling. The impact of this can normally be felt in everyday expenditure (wages and rate of employment) and a weakening in the domestic currency. Interest rates are also lowered by central banks when financial conditions are weakening and their lack of faith in the financial system. This could also be a sign of too much debt and the inability of individuals, businesses and even governments ability to maintain interest payments. In such economic conditions, the demand for gold increases as it acts as a store of wealth and value as a safe haven.
Traditionally, gold and interest rates have a negative correlation, which means that when interest rates go down, the price of gold goes up. Rising interest rates mean that investors look to stocks, government bonds and other investments. Lower interest rates make these same instruments less attractive, thus gold is more appealing. So far, the move into negative rates in some countries has maintained this correlation.
Inflation increases the value of gold as means of wealth accumulation while higher interest rates increase the costs of storing gold. It’s not uncommon to see inflation and interest rates falling in tandem so the key thing to remember is that inflation rates tend to affect gold prices over the longer term, while there is a clear negative correlation between gold and interest rates in the short term.
In theory deflation should decrease the price of gold as the relative value of cash increases. However, the feedback loop effect is that because central bank policy is so determined to avoid deflation any sign of it will enable central banks to aggressively expand monetary policy and increase the money supply in an attempt to counteract deflation. Conversely, this can have the effect of increasing the price of gold as the market can see evidence of an increase in the money supply, which usually is positive for gold.
Theory and Practice
Economics is frequently called the “dismal science” and economists frequently maligned for not being able to ever accurately predict recessions or expansions demonstrate by the adage that economists have “predicted 7 of the last 3 recessions”. Ultimately there are too many moving parts for any economic model to accurately predict how an economy will move in the future, or react to monetary policy. The famous US Baseball Coach Yogi Berra once mused “In theory there is no difference between theory and practice – in practice there is”. Economies are fluid and dynamic systems, dependent on various actions, behaviours and feedback loops. None of which can be successfully modelled at scale.
An example of this was during the financial crisis there was an outcry that all the “money printing” would create runaway hyperinflation. While there has been a huge rise in asset prices, prices of normal goods and services have remained relatively stable, and in some cases gone down. Hyperinflation may yet come, but it didn’t come as quick as the textbooks would suggest.
Understanding monetary policy remains important but it is crucial to examine how asset prices moves in reaction to policy and not just rely on what textbooks or economic theories dictate.