Golden Prospects

excerpt from the New York Times

A huge United States government deficit, low interest rates and rapidly growing money supply all add to the likelihood of renewed inflation — and a rising gold price. How high? Very.

The United States money supply grew slowly for a while in early autumn, but in the two months to Dec. 1 the St. Louis Federal Reserve’s “money of zero maturity” measure, essentially cash and similar instruments, increased at an 11.7 percent annual rate. That’s a return to the trend that lasted from 1995 to 2008, when the measure grew 3.6 percentage points faster than nominal gross domestic product.

The United States is not alone. Around the world, governments have implemented large stimulus packages. If they don’t want the borrowings to fund these to crowd out the private sector, they must be financed by creating more money.

That monetary expansion is not supposed to be inflationary, since the governments promise to take any money away before it can push up prices. Investors can be forgiven for skepticism. Higher inflation is at least possible once the global recession bottoms out.

Gold provides good insurance. Investment demand for it has increased rapidly in 2008, despite a falling price since June. The dollar value of gold demand was 45 percent higher in the third quarter than in the second, and 51 percent higher than the previous year, according to the World Gold Council. Supply has failed to keep up, with mine output up only 2 percent from the previous year and central bank sales down sharply.

Weak supply, strong demand and fears of inflation constitute a perfect mix of ingredients for a gold rally. Any surge into gold by hedge funds and other speculators could overwhelm the market, turning the rally into a bubble.

In January 1980, just before the Federal Reserve avoided an inflationary catastrophe, the gold price peaked at $875. That is $2,430 in today’s dollars. But the pools of speculative capital are much larger now than in 1980. A true gold bubble could well leave this benchmark far behind.