The Gold Price in Theory and Practice: A Primer on Real Interest Rates

By Martin Mesicek at Gold Source – Norway

Bloomberg wrote that gold prices are not behaving according to the theory. They illustrate the phenomenon by pointing out that gold prices rose in the wake of the Fed’s last three rate hikes, the first time in 2006, then in December 2015 and most recently last December.

Bloomberg’s theory purports that when interest rates on government debt or other fixed income securities goes up, owning gold, which pays no interest, become less attractive and the price should fall. That sounds intuitively right.

However, in the article Bloomberg fails to recognize that a change in interest rates that are less than changes in inflation affects the real interest rate. That is the rate that matters.

It helps little to get 10% interest if inflation is at 15%. A high nominal rate does not prevent earnings on interest rates to be eaten up by inflation, in this example purchasing power will still decrease by 5%. And since higher nominal interest rates are the central bank’s tool towards higher inflation, we can expect nominal interest rates to increase alongside rising inflation.

Can real interest rates explain periods of changes in the gold price better than nominal interest rates?

The Daily Gold have compared the gold price in dollars to real interest rates over time. The comparison shows that the gold price rises when real interest rates fall. It also shows that the gold price falls when real interest rates rise (even from negative levels). Stable positive real interest rates, i.e. periods where capital produce positive returns without significant risks, makes gold uninteresting, thus resulting in stable or falling gold prices.

Looking at inflation figures in the US from January, the annual core consumer price index (including food and fuel) was at 2.5%, which is higher than the stated target of 2%. When inflation increases and nominal rates stay the same, real interest rates decrease, making the opportunity cost of owning gold, rather than fixed income securities, lower thus boosts demand and eventually the gold price.

Hence, the theory that Bloomberg points out: that higher nominal interest rates will affect the gold price negatively finds little support. However, it is more likely that the gold price is affected by real interest rates.

Real interest rates offer a better explanation to changes in the gold price with the three recent interest rate hikes. In other words; even if those who say interest rates will rise in the coming years turn out to be right, this does not mean lower gold prices: on the contrary. If interest rates rise as a result of rising inflation, and inflation is rising more than the interest rate, real interest rates will become more negative thus increasing chances for higher gold price rather than lower.

You can always calculate your own real interest rates. There is no magic formula or strict rules for what interest rate you can use. You simply subtract inflation from any interest paying income. If you have deposits in high interest account, that pays 2% , and inflation is 2.8% , the real interest rate in this case is minus 0.8%. Saving in securities or bank deposits, which provide lower returns than inflation, is obviously not optimal over time and explains why savers rush into alternative means of saving like real estate, equities or gold.

So how high can the gold price go?

It’s a bit of a flippant question, but if we take a look at the negative real interest rates earlier in the graph from The Daily Gold, you’ll see that in 2011 they bottomed at nearly -4% (Real Fed Fund Rate) and -3% based on 5-year government bonds (Real 5-year yield). Back then the gold price was over 1900 usd per ozt.

Negative interest rates gradually moved towards positive until 2015, before turning negative again. That fits well with the gold price bottom in December 2015.

The current real fed fund rate is -1.88%, having decreased all through 2016 in tandem with a revived bull market in gold. Should real rates move as far down as levels seen in 2011, it could mean that the gold price may go higher than its previous peak in September 2011, especially considering that the price will start climbing from higher levels than after the financial crises triggered negative rates. One may see prices well over $ 2,000 per ozt.

[wps-social-ninja global-settings=”0″ show-count=”0″ show-before-post-content=”0″ show-after-post-content=”0″ align=”left” social-engines=”facebook,twitter,linkedin,googleplus,reddit” layout=”wps-sn-layout-round” /]