Fed's policy stance to push gold price down over the next few years, says Capital Economics
(Kitco News) Despite worrying inflation levels, gold is not likely to surge over the next few years as the U.S. Federal Reserve begins to tighten its monetary policy stance, according to a report by Capital Economics.
"While our forecast that high inflation in the U.S. will be more persistent than the markets expect should ultimately mean that investors demand higher inflation compensation, we also believe that a modest tightening of the Fed's monetary policy stance will drag real Treasury yields a bit higher. That should be enough to cause the gold price to fall over the next few years," said Capital Economics assistant economist Kieran Tompkins.
Gold does have a history of performing very well during periods of high inflation. But the key to gold's success is how persistent the price pressures are over the long term.
"While gold has performed very well as an inflation hedge in the last decade and a half, even outperforming the rise in the U.S. CPI, it has been less reliable over shorter periods. That is because it depends on whether short bouts of high and/or rising inflation have any impact on long-term expectations for inflation and interest rates," Tompkins said.
As economies have reopened across the globe, inflation has started to surge. In the U.S., price growth accelerated to a 31-year high in October, running at 6.2% on an annual basis.
"Rising inflation is generally bad news for financial markets. In the case of equities, higher inflation might raise the value of earnings, but that effect is usually outweighed by investors discounting the value of future earnings at a higher rate. Investors assume that higher inflation will go hand in hand with the central bank tightening monetary policy. It is a similar story for bonds, too, as the purchasing power of the future cash flows from bonds are eroded as inflation picks up," Tompkins wrote.
This inflation fear has brought gold back into the spotlight this fall as prices climbed back above $1,800 an ounce, and analysts are now targeting the $1,900 level.
"Gold is considered as an inflation hedge … The metal can be likened to a zero coupon bond that is held in perpetuity with infinite duration … Since gold effectively has a fixed nominal yield at 0%, its price won't downwardly adjust to higher inflation and expectations of tighter policy if expectations of the stance of real monetary policy are unchanged," Tompkins noted.
On top of that, it is also a self-fulfilling prophecy. "If there is collective belief amongst market participants that a certain asset will hold its value during periods of high/rising inflation, then market demand will rise in those circumstances. As a result, the collective belief raises the price and makes it an effective inflation hedge," he added.
Gold's reliability as an inflation hedge is only questioned when inflation surges for short periods of time, the report pointed out, noting that this is their base-case scenario for next year.
"And because the increase in inflation this year has generally been described so far as transitory, there hasn't been a rise in long-dated U.S. real Treasury yields. Indeed, these have even fallen slightly since the beginning of the year, reflecting expectations from investors that the Fed won't need to tighten the real stance of monetary policy very much to bring inflation back to target," Tompkins said.
Capital Economics projects that the Fed will begin tightening its monetary policy next year, and inflation will average 3% in 2022 and 2023 in the U.S., which will weigh on gold.
"We do think that there will be a modest tightening in monetary policy, causing real U.S. Treasury yields to grind higher," Tompkins added.
Back in July, Capital Economics estimated that gold would end the year at $1,750 an ounce.