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Where is the effect of inflation coming into the gold market?

October 5, 2012, 12:00 PM Przemysław Radomski , CFA

I am writing to get some perspective on why the price of gold is rising. Many commentators say that QE has contributed to the fear of inflation so many are running to gold. Yet QE has not produced inflation since the Federal Reserve is just buying financial notes and requiring the banks to hold more in reserves.

Where is the effect of inflation coming into the gold market? Is it China? Is it the fear of a financial Armageddon? Is it the euro and Europeans who are dealing with a recession which has gotten out of hand? Why is the price of gold just going up when the price of oil is tame and under control? What am I missing? Why have you not written about the German banks that will collapse under the weight of European sovereign nations defaulting on their obligations? Every commentator says that the German government should help the southern European countries but who will help the German banks? I realize that the only voice of sanity is coming from your articles, arguing that the sky is not falling. Thank you.

Much of the reply to your question depends on how one defines inflation. We prefer to use the old (old-fashioned?) definition that says that inflation is an increase in the general level of prices caused by increases in the money supply. According to this definition QEs don't really cause inflation - they are inflation. Yes, the Federal Reserve is buying financial notes (thus monetizing debt), but this is what causes the value of money to drop. By inflating (=decreasing in real terms) the overall debt levels, it allows for additional government spending in various forms.

The value of the dollar has to go down given the increased supply and no increase in demand - but what would it move down against? The euro? The Europeans will have to run their own printing presses in order to devalue their own debt levels and so will a large part of the world. Currencies will sink at similar rates so they will not seem to decline from the point of view of the exchange rates. However, they have to decline in value against real things like energy, food and gold, because while the number of papers with different symbols (a.k.a. fiat money) is unlimited, the supply of gold and crude oil is limited. Real things, tangibles, have real costs to produce and their supply cannot simply increase indefinitely.

That's why tangibles' prices will have to go up when monetary authorities around the world really start racing for the title of "most effective destroyer of currency value." In fact, this race is already underway and prices of commodities reflect that. Where was copper 10 years ago? Where was crude oil? Finally, where were precious metals? All of them were many times cheaper back then. The trend is already in place, and inflationary forces are ensuring that the commodities bull market remains in place.

Our take is that the German banks will not be allowed to collapse. We think that it's much more likely that the same thing will happen to them (if necessary) as with Greece: they will get money to prevent a collapse. Where will they get huge amounts of money? From the printing presses and the electronic means of creating money.

Do we think that the sky is falling? Generally, we do. However, we think that the upcoming global monetary crisis will not happen immediately. History shows that currency crises happen later than anyone expects and they are more profound and volatile than anyone assumed. Our gold and silver portfolio structure report reflects that - we suggest holding a portfolio that will keep you covered regardless of when the inevitable happens - tomorrow or in 20 years.

As for gold and oil, we suggest going to the reports section and reading about the relationship between gold, silver and crude oil in detail. In short, the relationship between the two is very loose, and they can even trade for months independent of each other. Precious metals and other commodities are in bull markets but they can move relatively independently in the medium- and especially short-term.

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