Gold prices are once again the talking point. Gold’s prospects are looking bright on strong investment demand despite worries of falling retail consumption. The commodity is factoring in the real price against global economic stress. Inflation adjusted gold prices are much higher, indicating that the current bullishness is not an asset price bubble.
The New York Mercantile Exchange’s (Nymex) Comex gold futures for June 2008 spurted to a high of $1033 an ounce in March 2008, extending the rally triggered by massive interest rates cuts by the US Federal Reserve. Surging crude oil prices also added fuel to the fire and gold prices were soon caught in a unforeseen frenzy.
Gold prices rallied in the late 1970s on oil price-led inflation and clocked a high of $850 an ounce in 1980. However, prices steadily declined over the next two decades before renewed-buying interest started gathering momentum in the gold market over the last few years.
A mining boom in the 1980s kept prices too low. By the time the Central Bank Gold Agreement (CBGA) was formed, the commodity was reeling around $300 per ounce. The CBGA was established in September 1999 to contribute to the stability in the gold market and help ensure that official gold sales were conducted in an orderly and predictable manner. The agreement provided for sales of 2,500 tonnes over five years ending September 2004. The next CBGA also provides for sale of the same quantity of gold over the next five years.
Before the CBGA came into effect, central banks lent huge quantities of gold to the market. They leased out gold not because they wanted to earn money, but to provide liquidity. The purpose of lending was to prevent a squeeze due to short-term increase in demand and/or cornering of the yellow metal by big speculators. Instead of achieving this purpose, however, the continuity with which they lent gold to the market at low lease rates capped prices of gold. The CBGA limited the amount of "leased gold" and curbed supplies.
Comparing gold prices with the US Consumer Price Index (CPI) for All Urban Consumers since 1980 reveals inflation adjusted gold prices and indicates that the current prices are fairly low in comparison with a broad basket of commodities. While the commodity rallied to an all-time high of $850 per ounce in 1980, it averaged $641 for the entire year. In the same year, the US CPI averaged 82.4 on an annual basis. The CPI averaged 213 in the first five months of 2008, while gold prices averaged $904 in the same period. These values correspond to a rise of 162% and 41% over the last 28 years, tilting the overall balance against gold’s favor.
In other words, gold has risen far less than prices of fuel, health care, food, education, and housing on central banks selling and leasing. It remained out of favor with most investors as governments and central banks have succeeded in masking the true extent of inflation. Inflation adjusted gold prices (see table: Discovering the value) work out to a mammoth $1680 per ounce in 2008.
The turmoil in the US economy is tied to a steadily weakening dollar. For many investors, gold is the currency of last resort. Gold prices, thus, are not really in a bubble territory. A true bubble can occur in an asset only when excessive supply is absorbed by pure speculative demand, pushing the asset’s value far above its "fair" value. Gold is right now sitting barely at half its bubble price of the 1980s when adjusted for inflation.
Unlike the bull market in the late 1970s, it is presumed that all the world’s major economies are currently in serious trouble. The fact that gold miners’ exploration outlays have risen for the sixth consecutive year since 2002 has also supported the metal. The real value of the commodity is, therefore, getting unlocked after a lull of more than two decades.
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