Last week, I wrote that it was highly uncertain whether the Fed, as it had promised, would raise interest rates twice more this year. The fact that gold prices initially reacted positively on the rate hike in mid-March, might indicate that the gold market also questions the future rate hikes that the Fed promised.

I finished last week by saying that I would comment on another fact of utmost importance with repercussions for precious metals markets. Here it is.

There is, indeed, another reason why the gold price continues to rise after the recent Fed rate hike. In general, we could argue that gold prices tend to go up when monetary policy is expansionary and tend to go down when monetary policy is restrictive.

As I said before, the Fed raised interest rates from 0.75 to 1 percent in March. This new target range means that U.S. monetary policy, from any point of view, ought to be called very expansionary. But, you might be thinking, what mostly counts in this matter are the future expectations regarding the Fed rate. That is completely correct! But we would still leave out the other half of the story.

To see whether monetary policy is expansionary, we tend to look at the nominal interest rate, currently at 1 percent, which is rather meaningless. To be able to conclude if monetary policy is expansionary or not, we must subtract the inflation rate from the official Fed rate or, in other words, calculate the real interest rate.

Far Below Normal

If we do this exercise with the figures for March this year, we arrive at the following outcome: the Fed rate equals, as mentioned earlier, 1 percent. The US inflation rate equals 2.7 percent in February (the most recent figure). This means that the real Fed rate currently equals -1.7%, not only far below zero percent, but miles away from the average real rate since 1984, which equals +2.7 percent. Economists estimate that the neutral real rate in the U.S., that is, the rate at which inflation neither increases nor decreases, would currently be somewhere between 1.5 and 3.5 percent.

Source: ST Louis fed

This, in turn, implies not only that monetary policy in the U.S., even after the recent rate hike, remains extremely accommodative, but even that monetary policy has been expansionary! A quick look at the above chart shows that the last time the real rate in the U.S. reached this level, was at the beginning of 2014. In other words, U.S. monetary policy has been less expansionary during 2015 and 2016 and even a great part of 2014 than it is now!

And the future? Let us assume that the central bank in New York does raise the official interest rate twice this year by 25 basis points on each occasion. The Fed rate would reach 1.5 percent on New Year’s Eve. If, at the same time, we assume that inflation remains unchanged, then real interest rates will remain substantially below the 0 percent line, far removed from both the earlier mentioned average since 1984 and the estimates for the neutral interest rate in the U.S. Even if we assume that inflation falls back to 2 percent, real interest rates remain negative.

If we assume an annual inflation of between 2 and 2.5 percent in 2018, and at the same time assume that the Fed raises the official rate three times this year – personally I consider this to be a remote possibility – then this would still mean that real rates in the U.S. would be around the zero percent in 2018 and – more importantly – far below the level of the estimated neutral interest rate.

Real Rates Are What Matters, Silly!

Why should all this be relevant for the gold price? Because, as I said before, the gold price tends to rise when monetary policy is (extremely) expansionary. The below chart is a clear demonstration of this tendency.

In the below chart, the nominal official rate and U.S. inflation, together with the gold price since 1970, are shown. It is clear that whenever inflation exceeds the Fed rate (which means that the real rate was negative), the gold price, with a small lag, skyrockets.

If history is any indication, fully acknowledging the fact that the real official rate in the U.S. is far below 0 percent and that is highly likely that this rate will reach, at most, 0 percent this year and next year, then it would not surprise me that gold prices continue to go up in that same period. Of course, the real rate is not the only factor that influences the gold price. Having said this: it is, overall, still an important factor.

st louis fed


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