Thanks for Acknowledging the Inflation Elephant

There’s always a dance between gold and inflation.

As an inflation hedge, gold should do well in inflationary environments. The rationale is two-sided. On one side, investors turn to gold to protect their wealth when inflation is eroding the value of bank accounts and bonds. That’s the classic inflation hedge/safe haven argument. On the other side, gold faces less competition as a safe haven when inflation is running because bonds perform poorly, with both capital and yield getting eroded.

That all says gold should go when inflation rises. But nothing is ever simple.

The complication here is that central banks usually raise interest rates to combat inflation. And higher rates reduce gold’s appeal from both sides: higher rates boost bond yields, helping the safe haven competition, and (2) higher rates cap the inflation that’s eroding bank accounts and keeping real yields negative (at least, that’s what rate hikes are supposed to do).

So how gold reacts to inflation depends on the context. New inflation in a low-rate environment probably supports the yellow metal while slowing inflation in a high-and-rising rate environment probably doesn’t. The Fed controls the wide swath in between through its hold on interest rates.

That brings us to today’s context. Today we have ultra-accommodative central banks buying hundreds of billions worth of bonds a month and holding rates at zero in an effort to revitalize economies in the wake of a pandemic.

It’s a strange context but not totally unfamiliar. Like it or not, we experienced similar in the wake of the Great Financial Crisis. And trying to inch rates and debts levels and central bank balance sheets back toward normal after that revealed how quickly the market fell in love with – indeed, became totally dependant on – ultra-supportive central banks.

In early 2018 the Fed attempted to shrink the balance sheet and normalize rates; by Q4 the stock market had almost crashed. So they eased and then tried again…and in September 2019 the repo market seized up (banks lending to banks, essentially) and the Fed had to restart QE.

So the Fed had made only the slightest progress away from Ultra Accommodative when COVID slammed us straight back into that setup. And a return to massive stimulus and ultra-low rates reinforced the trend that started in 2009: investors increasingly obsessed with central bank support.

It’s amazing, really, that markets have so quickly grown dependent on something that didn’t exist 11 years ago. But now the very suggestion of any kind of tightening sends shivers through, well, everything.

That a 25- to 50-basis point shift in rate projections two years out created such a violent reaction across asset classes lays the obsession bare. In some ways, the obsession is fair. Debt levels are super high, which means moving rates higher by any meaningful amount would almost certainly cause default and bankruptcy cascades (US debt-to-GDP now stands at 130%). On the stimulus side, QE has the Fed buying $120 billion in bonds every

month, a deep pool of demand that companies and governments (federal, state, municipal) all need because income doesn’t come close to matching spending.

And the fact that most financial assets (bonds) are now very long-dated also amplifies the impact of tightening, whether through rate hikes or less QE.

Bottom line: tightening is very tough, both because of sentiment (investors are obsessed with low rates) and because higher rates would have real repercussions. Powell knows all of this, of course. Yet in the face of strong inflation, he had to remind everyone that the Fed would raise the rate into persistent inflation because taming inflation is a big part of the Fed’s job.

But as I said two weeks ago, I think the reminder was done as much to tame the rates obsession as to actually lay the groundwork for rate hikes. Acknowledging the elephant in the room makes people less scared of elephants. And that’s helpful whether the elephant persists or transits off elsewhere.

On that: my friend Eric Coffin found this great chart from the Council of Economic Advisors that tries to piece inflation apart into ‘pandemic related and likely transitory’ and ‘normal’. The blue parts of each bar are services that are seeing intense boosts in demand because of reopening. Here we’re talking airfares, concert tickets, hotels, that sort of thing. The red parts are inflation changes related to vehicles – rentals, new and used purchases, price increases because COVID messed up supply chains, and the like. Vehicles are considered a pandemic factor because we didn’t need them to work from home and now need is ramping back up with reopening.

The chart shows that a lot of the inflation increases are transitory things but the grey bars, showing non-pandemic gains, are also bigger than they were pre-COVID and persistently so. So there’s persistent and transient inflation going on.

If this pattern sticks, a year from now inflation will have come down from its current crazy levels but won’t be as low as it used to be. I’m thinking 2 to 3%.

Inflation of 2-3% in an environment that freaks out for reasons both practical and obsessive with the suggestion of a 25- or heaven forbid 50-basis point hike means negative real rates going forward.

That foundation matters. And I think Powell’s play to acknowledge the inflation elephant in the room worked. The CPI numbers that came out yesterday – 5.4% year-over-year and 0.9% month-over-month – would have sent gold tumbling a month ago because anxious investors would have wondered when the Fed would act and hike rates.

Now those investors have some guidance: the Fed will act, sometime next year, if inflation proves persistent. With that guidance, they don’t have to stress. And the Fed has given itself several quarters to watch the numbers before having to do anything.

With stress levels lowered and no expectations of imminent action, it seems investors were able to react to the CPI print in a reasonable way. Gold dipped, recovered, dipped again, and then carried on (the red line below). And then yesterday it trended higher (the green line).

Here’s hoping sense prevails. Inflation will persist for months yet. As I’ve laid out, though, inflation will have to stay pretty hot for the Fed to do anything much about it, whether that’s raising rates a tic or easing back on bond purchases. For now, I think Powell’s acknowledgment of the inflation elephant has eased the obsession for a time, allowing gold to act on fundamentals. And that’s a good thing.