Why Does Slowing US Inflation Mean Good News for Gold Investors?

In the USA, there has been a notable decrease in the annual inflation rate, suggesting that the Federal Reserve’s cycle of interest rate hikes may have come to an end. This development bodes well for gold investors in the medium term. The primary factor exerting downward pressure on gold prices in recent years has been the rising interest rates.

In October, the US consumer price index saw a year-over-year increase of 3.2 percent, a slight decrease from the 3.7 percent recorded in September.

When comparing prices on a month-to-month basis with September, they remained virtually unchanged. Market expectations had anticipated a marginally higher inflation rate. However, when accounting for food and energy prices, the annual increase stood at 4 percent, marking the lowest rate observed in the past two years.

In response to this news, the price of gold experienced a surge of over one percent, with the price per ounce reaching $1,975 within the same day.

How Does Inflation and Interest Rates Affect The Price of Gold?

You might believe that reduced inflation could negatively impact gold prices, as gold is often seen as a hedge against inflation. While this is generally accurate, it’s important to consider that in the short to medium term, gold prices are also significantly affected by interest rates. When real interest rates (interest rates adjusted for inflation) are high, the opportunity cost associated with gold increases. Opportunity cost refers to the potential earnings lost when choosing one investment over another.

This implies that investors tend to favour bonds over other traditionally safe investments, such as gold, when real interest rates are higher. However, whether bonds are truly as safe as widely perceived, especially in today’s highly leveraged financial system, remains a separate and important consideration.

Over the long term, inflation plays a more significant role in influencing gold prices. Gold serves as a store of value, preserving its purchasing power across extended periods.

Besides inflation, gold prices are also shaped by fundamental factors like physical demand and supply dynamics.

Therefore, a decline in inflation rates suggests that the Federal Reserve may not need to increase interest rates further. Current market expectations indicate that there will almost certainly be no interest rate hike in December, and that the central bank may begin reducing rates as early as March. This scenario would lead to lower yields on bonds, consequently driving more investors to choose gold over bonds as a secure investment option.

The Movement of Gold and Real Interest Rates

Displayed below is the real interest rate for US 10-year bonds. Typically, when this interest rate rises, it exerts downward pressure on gold prices. Conversely, if the interest rate decreases, gold becomes more appealing to investors.

Observing the period immediately following the coronavirus crisis, we notice that the real interest rate turned negative. This indicates that inflation outpaced the interest earned on bonds. During this time, gold prices also reached new highs.

However, in the spring of the previous year, there was a rise in interest rates, which subsequently started to negatively impact gold prices. As real interest rates climbed above 2 percent in November 2022, gold prices plummeted to a multi-year low of $1,615 per ounce. Following this downturn, there was a resurgence in gold prices, and in May 2023, amidst the banking crisis, gold nearly set new price records.

Over the past six months, real interest rates have risen again, driven by the Federal Reserve maintaining high interest rates while inflation has swiftly declined.

As illustrated in the accompanying graph, the correlation between real interest rates and gold prices is not direct or consistent. Over the last five years, we generally observe that an increase in real interest rates correlates with a decrease in gold prices, and vice versa. However, the upward movements in gold prices have been more significant than the declines. This trend indicates a long-term upward trajectory for gold, fuelled by robust physical demand (notably central bank purchases), escalating inflation, expanding government budget deficits, extensive monetary expansion, and instability arising from various crises, such as the coronavirus pandemic and the recent banking crisis.

Navigating Inflation Slowdown and Potential Interest Rate Adjustments

Now, with inflation slowing more than anticipated, it’s widely believed that the Federal Reserve will refrain from further interest rate hikes. Instead, there’s a growing consensus that an economic recession is on the horizon, though its severity remains uncertain.

Should the central bank begin to reduce interest rates in response to a weakening economy?

Bond yields, particularly real yields, are likely to decrease as well. This scenario, however, tends to support and potentially increase gold prices.

Therefore, it is quite plausible that real interest rates will begin to decline in the coming year. This is expected as the Federal Reserve is likely to reduce interest rates more rapidly than the rate at which inflation decreases. Given that inflation peaked at 9.1% in 2022, it had significantly more scope to decrease compared to its current level of 3.2%.

Despite the recent slowdown in inflation, is it believe gold remains on a long-term upward trajectory. While a recession might temporarily exert pressure on gold prices, the fundamental factors underpinning its sustained rise remain intact. These include the record-high debt levels of various countries, substantial government budget deficits, strong physical demand, and inflation. Even though inflation is currently on a downward trend, it’s probable that if the economy worsens, monetary expansion will resume, potentially triggering another wave of inflation. It seems nearly impossible to alleviate record debt burdens without the presence of inflation.