This is a slightly modified version of a note I sent to a client institution:
In recent weeks, the price of gold in US dollar terms has dropped from around 1660 to around 1560 now. That is a 6% drop. Risk appetite has dropped. Investors have flocked to the dollar and yen. The scent of debt-deleveraging induced deflation is in the air. Hence, investors feel the need to abandon gold. It is strange. Investors have proven, time and again, to be myopic. The US dollar is no panacea. The Federal Reserve has expanded its balance-sheet more than the European Central Bank and the Bank of Japan have done since September 2008.
There is no threat of deflation. If anything, there is the threat of stagflation: low economic growth or recession combined with persistently above-target inflation in the US and in Europe. There are still persistent calls for the Federal Reserve to further expand its balance-sheet. In fact, many want the Federal Reserve to abandon any caution and buy risky assets aggressively. The latest to make this call is the Chief Economist for Citigroup. Willem Buiter was once a member of the Monetary Policy Committee of the Bank of England and then taught at the London School of Economics. He used to be critical of the bailout of financial institutions. Then, he joined one. Now, he is calling for helicopter dropping of money by the US and UK central banks.
FT subscribers can download the report written by Buiter here. The blog post in FT Alphaville on the Buiter note is here. I have written a lengthy comment on this brazenly irresponsible suggestion by Buiter in my latest MINT column.
There are rumours that Germany might loosen its stance on inflation and austerity and let the European Central Bank drop rates and expand the size of its long-term repo operations. All of these point to rising risks of stagflation because these measures will not lead to more economic activity but to more fear among the public that something is drastically wrong for countries to adopt such reckless policies. People will fear inflation tax and the government slapping higher taxes in future to make up for such aggressive policy measures. Therefore, they are unlikely to spend more. They are going to hold on to their cash more tightly than before. More likely that they would keep it under the carpet than even put it in banks.
At the same time, aggressive liquidity measures would boost speculation in commodities, cheapen the value of paper currencies relative to real assets and reverse the recent decline in commodity prices. In other words, aggressive monetary easing is more likely to result in higher inflation than in a growth pick-up. That is where the policy paths are leading to.
Perhaps, this is the ‘darkest before dawn’ for gold. Alternatively, the global financial order that was born in the 1980s and the paper money standard are on their last legs. Willem Buiter’s article reinforces the belief that fiat money backers are propelled by a death wish.