Gold and the global economy
The global economy is still booming in spite of the slowdown in the US. This is being driven largely by the powerful performance of emerging markets. US monetary policy accordingly will have to juggle domestic and global imperatives. The potential...
The global economy is still booming in spite of the slowdown in the US. This is being driven largely by the powerful performance of emerging markets. US monetary policy accordingly will have to juggle domestic and global imperatives. The potential combination of robust growth outside the US and more lax US monetary policies is likely to be supportive of gold prices. Emerging markets now play a pivotal role in the global economy. They are key drivers in the expansion of world trade and without them, there would be no global capital spending boom, which, is a major plank in the ongoing global economic expansion. As the primary drivers of trade and providers of capital, emerging markets are largely responsible for current buoyant global economic growth.
These same nations, however, are still dependent on monetary conditions as set by the US Federal Reserve. Given that the US is slowing, it is increasingly likely that the Federal Reserve will be forced to cut interest rates later this year. US monetary policies strongly influence monetary conditions in other countries, especially those countries whose currencies are linked to the US dollar.
Due to their robust growth and mounting inflationary pressures, lower US interest rates are highly inappropriate for most of the emerging world. Economic theory tells us that under this scenario, policymakers in the emerging world will have to accept either higher inflation or, alternatively, greater currency appreciation. The prospect of higher global inflation, or a weaker US dollar and stronger emerging market currencies, both appear to be bullish for gold.
The continued rapid economic acceleration of the emerging world and the slowing of the US economy are creating two divergent economic imperatives. The US is essentially facing the worst of all worlds. Growth is disappointing and inflation is uncomfortably high, given the Federal Reserve's target range. Although the expectation is for inflation fears to recede, growth is anticipated to remain weak.
The argument for lower interest rates is potent. US capital spending is weak, and the housing market is disappointing - with tighter lending standards for mortgages as a result of the sub-prime mortgage debacle, the slowdown in housing may intensify. Corporate profits, a heretofore mainstay of the economy, may also weaken as rising labour costs combined with an absence of pricing power will likely weigh on profit margins. The above makes it likely that the Federal Reserve will consider cutting interest rates this year.
Traditionally, lower US interest rates are supportive of gold prices as looser monetary conditions may weaken the US dollar and add to inflationary pressures. While lower interest rates might be the correct prescription for the US economy, it is doubtful if the same policy is right for much of the rest of the world. The US still fills an important role in the world economy and the US dollar is still the ''anchor'' currency for the world's monetary system.
Therefore, in addition to setting the US monetary climate, the Federal Reserve is also vastly influential in setting the global monetary climate. Given the robust economic expansion in much of the rest of the world, lower interest rates are not to the benefit of most economies and may be detrimental, as they could stoke inflationary pressures. The domestic US policy imperative under these circumstances thus clashes with the global imperative. Other occasions when the domestic and global imperatives followed their separate courses include the break-up of Bretton Woods in 1971, the 1992 ERM crisis, and the 1997 Asian crisis. On these occasions, the world was subject to extreme economic and financial market volatility, which had a profound impact on gold prices.
A split in imperatives raises a host of implications which may have important bearing on gold prices. Of these, the most important for gold are likely to be prolonged US dollar weakness, slower US growth, continued very strong growth within emerging markets, a threat of higher emerging market inflation, an unstable narrowing of global imbalances, and ambiguities over monetary conditions outside of the US.
There is a longstanding inverse relationship between gold and the US dollar that has been the subject of much academic and financial market study. Suffice to say the prospect of a weakening US dollar, holds the promise of higher gold prices. Strong growth in emerging markets would likely raise income levels and allow a greater proportion of the population to purchase gold.
The income effect may go some way towards mitigating the negative impact on jewellery demand of higher gold prices. Already, India is the largest consumer and importer of gold. Other emerging markets, such as the Middle East and China, are also important physical consumers of gold bullion. In addition, higher emerging market inflation would likely encourage gold purchases, if, more lax US monetary policies spur already booming emerging markets, thus pressuring inflationary rates higher.
If US global imbalances narrow too rapidly and in an unstable fashion, gold prices are also likely to benefit from the resulting increase in financial market volatility. Slower US growth, however, may weigh on US jewellery purchases, but this is unlikely to exert major downward pressure on gold.
In the near term, however, gold may be subject to a temporary sell-off as events unfold. Forecasts point to lower Federal Reserve funds by the end of the year, as fears of a US recession mount. However, the persistence of inflation in the short term, which is a reflection of strength elsewhere in the world, may prevent the Federal Reserve from lowering interest rates immediately. That said, as the US economy slows due to weaker consumer spending, a less optimistic outlook on profits, ongoing problems in the housing sector, tightening credit, and rising unemployment, the Federal Reserve will probably be forced to lower interest rates. Consequently, faced with a more lax Federal Reserve policy in response to deteriorating economic events, the knee-jerk reaction of the financial markets may very well be to sell risky assets, which would include gold.
• This report was compiled by Peter Calleya, manager corporate strategy and research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank
These same nations, however, are still dependent on monetary conditions as set by the US Federal Reserve. Given that the US is slowing, it is increasingly likely that the Federal Reserve will be forced to cut interest rates later this year. US monetary policies strongly influence monetary conditions in other countries, especially those countries whose currencies are linked to the US dollar.
Due to their robust growth and mounting inflationary pressures, lower US interest rates are highly inappropriate for most of the emerging world. Economic theory tells us that under this scenario, policymakers in the emerging world will have to accept either higher inflation or, alternatively, greater currency appreciation. The prospect of higher global inflation, or a weaker US dollar and stronger emerging market currencies, both appear to be bullish for gold.
The continued rapid economic acceleration of the emerging world and the slowing of the US economy are creating two divergent economic imperatives. The US is essentially facing the worst of all worlds. Growth is disappointing and inflation is uncomfortably high, given the Federal Reserve's target range. Although the expectation is for inflation fears to recede, growth is anticipated to remain weak.
The argument for lower interest rates is potent. US capital spending is weak, and the housing market is disappointing - with tighter lending standards for mortgages as a result of the sub-prime mortgage debacle, the slowdown in housing may intensify. Corporate profits, a heretofore mainstay of the economy, may also weaken as rising labour costs combined with an absence of pricing power will likely weigh on profit margins. The above makes it likely that the Federal Reserve will consider cutting interest rates this year.
Traditionally, lower US interest rates are supportive of gold prices as looser monetary conditions may weaken the US dollar and add to inflationary pressures. While lower interest rates might be the correct prescription for the US economy, it is doubtful if the same policy is right for much of the rest of the world. The US still fills an important role in the world economy and the US dollar is still the ''anchor'' currency for the world's monetary system.
Therefore, in addition to setting the US monetary climate, the Federal Reserve is also vastly influential in setting the global monetary climate. Given the robust economic expansion in much of the rest of the world, lower interest rates are not to the benefit of most economies and may be detrimental, as they could stoke inflationary pressures. The domestic US policy imperative under these circumstances thus clashes with the global imperative. Other occasions when the domestic and global imperatives followed their separate courses include the break-up of Bretton Woods in 1971, the 1992 ERM crisis, and the 1997 Asian crisis. On these occasions, the world was subject to extreme economic and financial market volatility, which had a profound impact on gold prices.
A split in imperatives raises a host of implications which may have important bearing on gold prices. Of these, the most important for gold are likely to be prolonged US dollar weakness, slower US growth, continued very strong growth within emerging markets, a threat of higher emerging market inflation, an unstable narrowing of global imbalances, and ambiguities over monetary conditions outside of the US.
There is a longstanding inverse relationship between gold and the US dollar that has been the subject of much academic and financial market study. Suffice to say the prospect of a weakening US dollar, holds the promise of higher gold prices. Strong growth in emerging markets would likely raise income levels and allow a greater proportion of the population to purchase gold.
The income effect may go some way towards mitigating the negative impact on jewellery demand of higher gold prices. Already, India is the largest consumer and importer of gold. Other emerging markets, such as the Middle East and China, are also important physical consumers of gold bullion. In addition, higher emerging market inflation would likely encourage gold purchases, if, more lax US monetary policies spur already booming emerging markets, thus pressuring inflationary rates higher.
If US global imbalances narrow too rapidly and in an unstable fashion, gold prices are also likely to benefit from the resulting increase in financial market volatility. Slower US growth, however, may weigh on US jewellery purchases, but this is unlikely to exert major downward pressure on gold.
In the near term, however, gold may be subject to a temporary sell-off as events unfold. Forecasts point to lower Federal Reserve funds by the end of the year, as fears of a US recession mount. However, the persistence of inflation in the short term, which is a reflection of strength elsewhere in the world, may prevent the Federal Reserve from lowering interest rates immediately. That said, as the US economy slows due to weaker consumer spending, a less optimistic outlook on profits, ongoing problems in the housing sector, tightening credit, and rising unemployment, the Federal Reserve will probably be forced to lower interest rates. Consequently, faced with a more lax Federal Reserve policy in response to deteriorating economic events, the knee-jerk reaction of the financial markets may very well be to sell risky assets, which would include gold.
• This report was compiled by Peter Calleya, manager corporate strategy and research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank