Gold is affected by several variables, including interest rates, inflation, the value of the dollar, demand trends, and economic and political developments. The future direction of the U.S. Fed monetary policy, stock market volatility, a looming debt crisis, and potential supply/demand-side shocks will all play critical roles in defining the future of gold.

Is inflation “Transitory?”

In light of the current inflation crisis, let us first examine the future direction of U.S. monetary policy. It has become inevitable that the Fed will begin winding down its stimulus spending program, brought about by the negative repercussions of the recent Covid-19 crisis. Due to the persistent nature of the current inflationary pressures, the Fed would increase interest rates in an effort of curbing consumers’ spending patterns and putting the brakes on inflation. However, the downside to such a contractionary policy is that it might restrict aggregate demand and real economic growth. Moreover, suppose interest rates on U.S. treasuries increase. In that case, it becomes less appealing for people to invest in gold, as its relative cost increases compared to other dividend or interest-yielding securities. Higher yielding U.S. securities can also mean a stronger dollar, as investors’ demand for the dollar increases due to favorable investment opportunities in U.S. equity and debt markets. Higher interest rates and a stronger dollar would curb demand for gold and exert downwards pressure on the price.

Others, including the U.S. Fed itself, had previously argued that the current inflation crisis is “transitory” and mainly prompted by the Covid-19 recovery period. The word “transitory” here means temporary, but the problem is that it does not set a time limit, so for arguments case, inflation can be transitory for a year or a decade. By mid-2021, we have seen prices soar as economies re-opened and consumer spending intensified. But because of supply chain disruptions brought upon by the Covid-19 pandemic, the sudden and massive rush of demand could not be met by sufficient supply levels, triggering what is referred to as “demand-pull” inflation. Furthermore, the Fed argued that as supply chain disruptions gradually subside, heightened consumer demand will be met by equivalent and sufficient supply levels, eventually curbing inflation, and achieving the coveted “market equilibrium.” In this “laissez-faire’ approach, interest rates would be left unchanged, and hypothetically the economy would take its natural course of achieving market stability. Still, it is becoming more evident that would be an unlikely scenario. Low-interest rates and high short-term inflation would be welcome news for gold, as it may trigger increased demand for gold, ultimately bolstering prices. Others also argue that even rate hikes on long-term U.S. treasuries might not be enough to tame inflation because of persisting supply-side disruptions. Therefore, we might as well see interest rate hikes, but with no apparent down-ward pressure on inflation, which may also support gold prices.

Stagflation, a Debt Crisis, and Stock Market Volatility

Stagflation is simply a state of high inflation and economic recession. This may be a little counter-intuitive to some because inflation means increased demand and consumer spending, which in turn means real economic growth. But as discussed earlier, today, we are encountering supply-side risks, where adverse supply shocks are bolstering inflation. Supply-side shocks can also severely affect economic output and lead to a recession, triggering the highly feared state of stagflation. Because stagflation is defined by low overall demand, employment, and economic output, it may threaten gold. Gold prices are heavily affected by people’s demand and much less by supply shocks, as historically, the supply of gold has proven to be somewhat limited and constrained. Therefore, some argue that supply-side fueled stagflation may not necessarily exert downwards pressure on gold prices; instead, low levels of recession-driven demand will.

A critical rule of inflation is that when inflation increases, the value of a currency declines over time. On the same note, the money used to pay future debt obligations would become worthless in value compared to the money borrowed in the past. This, in effect, can decrease the real nominal value of debts and reduce countries’ debt burden. However, in the past, countries’ debt ratios were nowhere near today’s, and high inflation (more notably during the 1970’s oil crisis, which saw a massive 300% increase in oil prices) was able to control and minimize levels of future debt obligations. On the flip side, during the 07-08 financial crisis, both public and private debt levels were at an all-time high, but the financial crisis had delivered a massive hit to aggregate demand, which caused deflation. In today’s world, we may be experiencing the fatal mix of both high debt levels and supply-side fueled inflation, which may very well exacerbate and expedite the inevitable debt crisis and plunge the world economy into gradual stagflation. In this case, potential volatility in the equity markets would ensue, which in the short-term can cause investors to flock to gold to diversify and hedge their portfolios; this would increase gold prices or at least stabilize them. It is noteworthy to mention that historically gold might have lost value in particular periods but has never lost its entire worth, like other debt and equity securities did.

Increased or Decreased Demand?

Strong demand from India and China can play a significant role in supporting gold prices. Both India and China are two of the world’s largest economies and naturally contribute their fair share of worldwide gold demand. As both economies grow and citizens’ purchasing power increases, we may see heavy gold consumer demand from the region. On the other hand, both India and China being major trade partners to almost every country of the world, may sustain severe losses brought about by future demand/supply shocks. This would have detrimental effects on consumers’ purchasing power and, therefore, curtail demand for gold, ultimately exerting downwards pressure on prices.

Central banks may also be increasing their gold allocations to hedge their reserves against the impending threat of inflation and a weak dollar. This would also play a key role in bolstering demand for gold and might as well make up for decreased consumer demand brought about by a potential debt crisis and an ultimate recession.

The Bottom Line

In the current global finance and economics world, “uncertainty” is prevalent. Some argue that the worst is yet to come, and others argue that our intricately built international monetary system can weather any storm that comes its way. In all cases, one thing we know for certain is that gold has withstood the test of time and has been able to safeguard its value for thousands of years. But will future crises be too much for gold to handle? That is yet to be discovered.