21 July 2011 – Macro Insight




Macro Insight: Gold in the Really Long Run

Gold has surged 500% in just ten years and recently touched a new all-time high of $1,601 an ounce. Adjusted for inflation, the price of gold was even higher back in 1980 when it reached nearly $2,000 in today’s dollars, suggesting this rally could have more to go. However, gold prices can plunge just as dramatically, as they did in the early 1980s. After all the swings, the real return from gold over the long run is about the same as a US T-Bill but with a whole lot more volatility.

For most of modern history, global currencies were fixed to the price of precious metals like gold and silver and only changed when the monetary authorities of the day adjusted their pegs. In the US, the nominal price of gold in dollar terms changed very little through the nineteenth century: gold was $19 in 1800, briefly doubled to $42 during the Civil War, and was back to $21 until the Great Depression.

By taking inflation into account, the real price of gold (the yellow line in the chart) can better reflect how the value of gold changes over time. For instance, during the Civil War, gold jumped to over $1,000 in today’s dollars. It was worth $650 through the rest of the century, dipped under $250 during the 1920s, jumped again during the Depression, and settled back down to around $200 by the end of the 1960s. When the gold standard broke down in the 1970s and central banks were free to print money, inflation accelerated into double digits by the end of the decade. Gold spiked to new highs until the Fed finally put a definitive end to the long era of easy money. With inflation headed back down, real gold prices around the world fell for the better part of the next two decades.

A new era of easy money returned in the 2000s when the tech bubble burst and central banks around the world slashed interest rates. In the US, the Fed pushed interest rates down to historically low levels and kept them there until 2004. Meanwhile, the excess liquidity created the conditions for the global credit crisis that erupted in 2008. Once again the Fed slashed rates, this time all the way to zero, and then launched two rounds of quantitative easing. After taking inflation into account, the real federal funds rate has been negative more often than not since 2001, a sustained period of monetary stimulus that exceeds even the 1970s. Gold has duly surged.

The surge in gold will eventually come to an end. If recent history is any guide, the turn will be accompanied by a clear shift in US monetary policy, as China, the ECB, and other central banks have already started to do. Whenever it comes, the plunge could be dramatic: gold would need to drop nearly 70% in dollar terms to reach its historic inflation-adjusted average. Over time, the huge swings in gold prices tend to cancel out, leaving a real return of just 1.2%. As it happens, the real return on T-Bills over the last fifty years is also 1.2%. Gold shines when currencies are losing their value, but it loses its luster in the really long run.



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