In this article we will examine the relation between the gold price, interest rates and inflation.
Though not a real follow up, this article does mention another way in which central banks can put pressure on markets, in addition to what was mentioned in 25 Central banks.
1 Why is the gold price affected by inflation and interest rates
The primary reason is that gold is considered a safe heaven, plus highly liquid asset. So it can be bought and sold at a moments notice, without any genuine risk (assuming reputable partners are being used).
It is considered a form of wealth storage, so used instead of putting money in the bank, as such it is affected by the same things as money in the bank; inflation and interest rates. It is also generally advised as a diversification of your portfolio.
2 Interest rates
This is the real kicker, since gold is considered money: A high real rate of interest (interest minus inflation), including offered on bonds, will result in a decreased gold price as holding bonds or money with a bank will be more profitable. Remember that there is only a cash return when you sell gold. So getting money on a regular basis will always be an advantage that most other assets have over the hallowed yellow metal.
Low interest rates tend to increase the market value of gold, since there is no real cost of missed opportunity (foregone interest by turning money into gold). With interest offered on bonds there is the added risk that a bond issuer can go bankrupt, gold will always have a practical value so has a minimum value as a resource, mostly for electronics, which will likely be in high demand the coming century.
Interest is sometimes considered as the cost of holding gold, since that is what you are missing out on. There are also direct costs of buying and holding gold (premium, transportation, insurance, storage, etc.).
3 Inflation
During times of high inflation it is better to buy gold than store money in a physical or banking form, because the money will become less valuable over time. Where gold will increase in value, so you can sell your gold after inflation cooled down, at a higher price.
There is a secund side to this; corporate equity is also suitable for inflation, since a company can increase its product’s prices, thereby increasing profit resulting in a higher share price. So it kind of depends on why there is inflation, if there is a risk to corporate activity.
4 Equilibrium
Above we have stated that high inflation increases the gold price, but what we omitted is that a high percentage of inflation forces central banks to increase their interest rate, which negatively affects gold. Resulting in both a negative and a positive effect.
This, theoretically, works out as follows: If central banks do not increase interest rates by enough, inflation wins and so does gold. If interest and inflation are fairly matched, gold stays around the same price point. In a situation where bankers overreact and publish excessive interest rates, gold will tumble.
5 Gold supply
Besides that a high gold price means more supply in recycled gold (bars, coins and other investments being sold, plus advertisers pushing people to sell their inherited jewellery), there really is no effect on mined gold, based on price.
A negative effect in newly mined ore would be the result of a negative cost assessment for each corporation involved in the trade; something unlikely to happen under normal circumstances. The most likely reason for miners to stop are energy costs, cost of reaching the gold itself (price is a factor, so is inflation) or because supply is running out. At moment of writing, a shortage in gold veins that can be reached, without excessive costs, is a genuine risk for new supplies of gold. Jewellers and dealers have at times temporarily stopped trading during excessive price fluctuations, the exact same things happened on stock exchanges so nothing special.
