Gold Market Going Back Into The 1970s

1. Gold Market Going Back Into The 1970s

2. Points To Be Covered Today:
• Is Gold Market Going Back Into The 1970s?
• Gold Under Fed's New Monetary Regime
• Will the Bomb Explode, Igniting Gold?
• Gold As An Inflation

3. Is Gold Market Going Back Into The 1970s
• They say that time travels are impossible. But we just went back to the
1960s! At least in the field of the monetary policy. And all because of a new
Fed’s framework.
• So, please fasten your seat belts and come with me into the past and
present of monetary policy – to determine the future of gold!
• At the end of August 2020, the Fed has modified its Statement on Longer-
Run Goals and Monetary Policy Strategy – for the first time since its
creation in 2012. As a reminder, the Fed will now target not merely a 2
percent rate of inflation, but an average inflation rate of 2 percent, which
allows overshooting after the periods of undershooting.
• So, the Fed will try to compensate for periods of low inflation with periods
of high inflation.
• Hence, on average, we will see a more accessible monetary policy and
higher inflation -Good news for the gold bulls.

4. Is Gold Market Going Back Into The 1970s - I
• One of the many problems with the Fed’s new regime is that we do not know how
long will be the period over which the US central bank will average inflation, or
what does it mean that the Fed will tolerate temporaral inflation over 2 percent –
it’s not hard to see that practically any policy action could be justified through an
appropriate choice of the period’s length.
• The second significant shift within the Fed’s strategy is a different reaction
function. So far, the Fed reacted (at least in theory, the practice was a different
kettle of fish) symmetrically to both upward and downward deviations from the
natural rate of unemployment.
• When the economy approached full employment, the Fed started its tightening
cycle to prevent overheating and the rise of inflation. Now, the US central bank
will be informed by assessments of the shortfalls of employment from its
maximum level.
• It means that the Fed learned to stop worrying about overheating and loved
the inflation bomb.

5. Is Gold Market Going Back Into The 1970s - II
• The US central bank believes now that a robust job market can be
sustained without causing an outbreak of inflation, so it will not
hike interest rates preemptively, based on the signals coming from the
labor market and other segments of the economy, but will wait for inflation
to materialize and act only later.
• Such an approach may seem right, especially after several years of low
inflation.
• So why to worry about its rise?
• Why hike interest rates too early and kill an economic expansion?
• However, the Fed risks that inflation will get out of control. And that
the US central bank would be surprised and its reaction would be delayed.
In such a scenario, which is not unprecedented, the Fed will have to
tighten its monetary policy to curb inflation aggressively. As a former Fed
Chair William McChesney Martin said, the central banker's job is to “take
away the punch bowl just as the party gets going.”

6. Is Gold Market Going Back Into The 1970s - III
• At some point, the punch bowl has to be taken away, no matter how much
the guests object.
• But the longer the party goes on, and the more drunk participants are, the
harder it is to take the vase. If inflation exceeds 2 percent and continues its
climbing, the Fed will have to take away the punch bowl very abruptly,
much more aggressively than earlier and preemptive actions.
• Indeed, this is why the Fed’s new monetary regime takes us back to the
1960s and, possibly, to the 1970s.
• Then as today, policymakers put a high priority on achieving full
employment relative to price stability.
• The Fed mistakenly believed that unemployment's natural rate was lower
than it was, so the inflationary pressure was unlikely to emerge.

7. PCE & CPI Inflation Rates
• Please look at the chart again. As one can
see, high inflation did not show up overnight.
• Instead, it began to pick up in the late 1960s,
together with massive fiscal deficits (high
deficits – don’t they look familiar?) caused by
the Vietnam war and “Great Society”
programs. But despite the upward trend in
inflation since 1965, the Fed remained
focused on full employment, believing that
inflation would subside, based on an overly
optimistic view of the economy’s potential
output and natural unemployment rate.
• As a result, the monetary policy remained
overly accommodative, with interest rates too
low until Paul Volcker came and hiked
the federal funds rate aggressively to almost
20 percent in the early 1980s

8. Effective Federal Fund Rates
• The Volcker’s aggressive tightening
was clearly bad for gold, which
entered a bear market.
• However, the 1970s, when the Fed
was behind the inflation curve, was an
excellent period for the yellow metal.
• History never repeats itself, but the
Fed’s new strategy increases the risk
of replaying the unpleasant past (as
well as the increased broad money
supply in response to the coronavirus
crisis).
• Even if the 2020s only rhymes with
the 1970s, they should still be
positive for the gold prices.

9. Gold Under Fed's New Monetary Regime
• In August 2020, Federal Reserve Chair Jerome Powell delivered his Jackson Hole
speech, unveiling a new monetary framework in the process.
• He announced a flexible average inflation targeting strategy (FAIT). The new regime
implies that when the inflation undershoots its target in one period, the US central bank
will try to push inflation above the target in the next period to compensate for the previous
shortfalls.
• In other words, after periods of persistently low inflation, the Fed "will likely aim to achieve
an inflation moderately above 2 percent for some time," as said in the
amended Statement on Longer-Run Goals and Monetary Policy Strategy.
• In plain English, the Fed announced that it will accept an inflation that is somewhat
higher. And that it will not continue its standard approach, in use at least since Paul
Volcker, and it will not raise interest rates to curb climbing inflation.
• But shouldn't the central bank rather try to achieve the price stability and protect the
society against high inflation? Of course it should.
• However, the recent years of low inflation persistently below the Fed's target of 2 percent
(here I mean low consumer price inflation, and asset price inflation that is significantly
higher), which are presented in the chart below, raised doubts in the marketplace about
whether the US central bank is able to generate higher inflation at all.

10. PCE & CPI Inflation Rates

11. 5 & 10 Year Inflation Expectation

12. 5 & 10 Year Inflation Expectation - I
• The shift to the FAIT is a big move that should be positive in the long run
for gold, which is considered an inflation hedge.
• But, perhaps even more important is the change within the employment side of
the Fed's mandate. Under the previous strategy, the maximum employment goal
referred to the natural rate of unemployment that would be consistent with stable
inflation in the long run.
• When the Fed expected the unemployment rate to fall below its estimate of the
rate of unemployment that would not accelerate inflation, it raised the federal
funds rate to prevent the increase in inflation.
• Under the new regime, the Fed will not hike interest rates preemptively and
unless there are visible signs of accelerating inflation.
• It means that the FOMC will prioritize employment and economic growth over
inflation and will not impede recoveries unless the inflation target is severely
threatened.
• Hence, both major revisions - in the inflation and employment objectives -
are fundamentally positive for the gold prices. It does not, however, mean
that we will immediately see double-digit inflation.

13. The Inflation And Employment Objectives - Are
Fundamentally Positive For The Gold Prices
• Both major revisions - in the inflation and employment objectives - are
fundamentally positive for the gold prices. It does not, however, mean that we will
immediately see double-digit inflation. After all, the Fed could not generate inflation in line
with the target, so why it should boost it above the target, even temporarily?
• But the US central bank has given itself room to loosen its monetary policy for years. The
interest rates will remain close to zero for longer than it would be appropriate under the
old regime, as the Fed will not try any longer raise interest rates to preempt inflation.
• In other words, the central bank is not likely to hike the federal funds rate until inflation is
above 2 percent for some time - according to the recent Fed's dot-plot, this is not going to
happen before 2024. Hence, the Fed's new framework implies lower real interest
rates - is good news for the precious metals investors.
• And the risk of inflation getting out of control should also support the gold prices. After all,
as former Fed Chair William McChesney Martin Jr. said, "the effective time to act against
inflationary pressures is when they are in the development stage--before they have
become full-blown and the damage has been done".
• It seems that the Fed has forgotten this truth. Well, those who cannot remember the past
are condemned to repeat it. Although this statement has negative connotations, I believe
that gold bulls would like to relive the 1970s!

14. Will The Bomb Explode, Igniting Gold
• The bomb can explode one day. And I do not mean here
missiles from North Korea, Iran or China.
• Neither I think about the viral threat - the coronavirus
bomb has already blown up in spring, dragging the
world into deep economic crisis.
• I have in mind the U.S. debt bomb. Just take a look at
the chart below. As one can see, the public debt has
reached 107 percent of the GDP even before
the pandemic.

15. US Federal Debt To GDP

16. US Federal Debt To GDP - I
• And it further increased in the second quarter of 2020, possibly even to around 137
percent, according to the U.S. National Debt Clock.
• Although the surge in the ratio of debt-to-GDP partially resulted from the unprecedented
collapse in the economic activity triggered by the epidemic and the Great Lockdown, it
was also driven by the vast additional government expenditures.
• As revenues declined, the fiscal deficit is expected to balloon from $984 billion, or
4.6 percent of GDP, in fiscal year of 2019, to $3.7 trillion, or 17.9 percent of GDP in
2020, according to the CBO. In consequence, the already high public debt is forecasted to
increase even more. And Fitch has already downgraded its outlook on the U.S. debt from
stable to negative.
• Some economists claim that government stimulus financed by debt was necessary given
the disastrous economic effects of the coronavirus crisis.
• Maybe it was, maybe not (we believe that increased spending on health should be
accompanied by spending cuts in other areas) - but one thing is certain. When the battle
with Covid-19 will be won (and it will be!), the policymakers will need to detonate the
debt bomb.

17. Ways Supportive For Gold Prices
• The first is obvious and the less harmful one in the long-run. The
government could reduce its excessive spending and, thus, fiscal deficits,
stabilizing the ratio of debt to the GDP. Unfortunately, it is the most difficult
option from the political point of view, especially when both Trump and
Democrats talk about the need of more economic stimulus and higher
spending on infrastructure.
• Second, the government could hike taxes to raise more revenues, filling
the budget hole. Trump is unlikely to raise taxes, but if Biden wins, higher
taxes for the richest are possible. Although they would reduce the fiscal
deficits, hiking taxes, especially in the aftermath of the recession, would be
harmful for the economic growth.
• All this means that policymakers will be tempted to reduce the public debt
through either higher inflation or financial repression.
• Both ways are supportive for the gold prices.

18. Gold As An Inflation Hedge
• Gold is believed to be an inflation hedge, so the increase in inflation - or mere inflation
expectations - would increase the demand for gold and its price. Moreover, higher inflation
means lower real interest rates - which would also make the yellow metal shine. So,
attempts to inflate away the debt would weaken the greenback, lower the already ultra-
low real bond yields, and support the gold prices.
• Financial repression is maybe less spectacular but also positive for the yellow metal. It
works as follows: the government caps the interest rates that financial institutions are
allowed to pay.
• The idea is simple: thanks to the financial repression, government can borrow cheaper
than it could otherwise because people simply are not allowed to get better returns
elsewhere. This method wouldn't be unprecedented, as it was used to reduce the high
public debt after World War II.
• Oh, by the way, the interest-rate ceilings were lower than the rate of inflation, so creditors
received negative returns in real terms.
• It goes without saying that gold should shine during financial repression. After all, the
argument that gold doesn't pay interest would be less convincing in the world where other
assets offer scant yields or even negative returns in real terms.

19. Gold As An Inflation Hedge - I
• Yield curve control contemplated by the Fed would be that kind of financial repression, as
it would also aim to keep the Treasury yields at sufficiently low level to reduce the debt-to-
GDP ratio over time.
• If implemented - so far the U.S. central bank has not endorsed the idea - it would maintain
ultra-low interest rates with all their negative consequences, such as: the prevalence of
zombie companies and misallocation of capital, the search for yield and excessive risk-
taking, the rise in private indebtedness, etc.
• Moreover, the ultra-low interest rates could lead to capital outflows, which would weaken
the U.S. dollar, while strengthening gold.
• Last but not least, the pledge to keep interest rates at very low level could require the
Fed to let inflation turn hot, which would also support the gold prices.
• To sum up, high public debt will be one of the most significant legacies of the coronavirus
crisis. The efforts to reduce it will become an important element of the political debate in
the upcoming years, as policymakers will realize - sooner or later - that they are sitting on
a ticking time bomb.
• It seems that financial repression will be the preferred method of reducing the high debt-
to-GDP ratio, dominating the investment outlook in coming years.
• Precious metals investors holding gold should benefit from negative real interest
rates.

20. Gold Market Going Back Into The 1970s

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Gold Market Going Back Into The 1970s