On the Relationship Between the Size of the Monetary Base and the Price of Gold

The strong correlation between the gold price, and the size of the US monetary base that has existed during the era of quantitative easing appears to be in breakdown:


To emphasise that, look at the correlation over the last year:


Of course, in the past the two haven’t always been correlated. Here’s the relationship up to 2000:


So there’s no hard and fast rule that the two should line up.

My belief is that the gold price has been driven by a lot of moderately interconnected factors related to distrust of government, central banks and the financial system — fear of inflation, fear of counterparty risk, fear of financial crashes and panics, fear of banker greed and regulatory incompetence, fear of fiat currency and central banking, belief that only gold (and silver) can be real money and that fiat currencies are destined to fail. The growth in the monetary base is intimately interconnected to some of these — the idea that the Fed is debasing the currency, and that high or hyperinflation or the failure of the global financial system are just around the corner. These are historically-founded fears — after all, financial systems and fiat currencies have failed in the past. Hyperinflation has been a real phenomenon in the past on multiple occasions.

But in this case, five years after 2008 these fears haven’t materialised. The high inflation that was expected hasn’t materialised (at least by the most accurate measure). And in my view this has sharpened the teeth of the anti-gold speculators, who have made increasingly large short sales, as well as the fears of some gold buyers who bought a hedge against something that hasn’t materialised. The global financial system still possesses a great deal of systemic corruption, banker greed and regulatory incompetence, and the potential for future financial crashes and blowups, so many gold bulls will remain undeterred. But with inflation low, and the trend arguably toward deflation (especially considering the shrinkage in M4 — all of that money the Fed printed is just a substitute for shrinkage in the money supply from the deflation of shadow finance!) gold is facing some strong headwinds.

And so a breakdown in the relationship between the monetary base has already occurred. Can it last? Well, that depends very much on individual and market psychology. If inflation stays low and inflation expectations stay low, then it is hard to see the market becoming significantly more bullish in the short or medium term, even in the context of high demand from China and India and BRIC central banks. The last time gold had a downturn like this, the market was depressed for twenty years. Of course, those years were marked by large-scale growth and great technological innovation. If new technologies — particularly in energy, for example if solar energy becomes cheaper than coal — enable a new period of spectacular growth like that which occurred during the last gold bear market, then gold is poised to fall dramatically relative to output.

But even if technology and innovation does not produce new organic growth, gold may not be poised for a return to gains. A new financial crisis would in the short term prove bearish for gold as funds and banks liquidate saleable assets like gold. Only high inflation and very negative real interest rates may prove capable of generating a significant upturn in gold. Some may say that individual, institutional and governmental debt loads are now so high that they can only be inflated away, but the possibility of restructuring also exists even in the absence of organic growth. A combination of strong organic growth and restructuring would likely prove deadly to gold.

21 thoughts on “On the Relationship Between the Size of the Monetary Base and the Price of Gold

  1. Strong organic growth and restructuring? Seriously? Are there two LESS likely developments than those over the next several years?

    • At some point alternative energy prices are going to fall below fossil fuel prices, and it’s going to be the biggest boom you have ever seen — and quite possibly a new paradigm.

      • In the next few years? Please. There is tremendous pressure from those (very powerful) people/entities who/which benefit from fossil fuesl, and that alone is almost certain to drag things out.

        • Well that is only one possibility for organic growth so even if it doesn’t materialise there are plenty of other possibilities. I have been seriously bullish about gold for the last five years, but I think maybe I was underestimating chances of some large-scale organic growth. There are still some seriously innovative sectors and people out there. People like Elon Musk are the tip of the iceberg.

  2. Aziz,

    Have you considered the aspect that the dollar price of gold also includes what many refer to as “unallocated gold”? If there is a price drop due to head to head clashes against leveraged paper shorts vs. leveraged paper longs, the plunge is actually a good thing since that shakes the weak hands off the market.

    Specifically, you are looking for a correlation between monetary base and physical + credit gold, which is going to obscure the real relationship between simply physical gold and the monetary base.

    • This would be true if we had permanent backwardation… Right now, the paper can sometimes trade at a premium to the physical…

      Remember there are massive pre-existing gold reserves, too, and some of these (currently valued around $8 trillion in total) can often be brought to the market almost as easily as a paper contract.

  3. I own allocated, segregated, serialized bullion, and am not in the least concerned with its current dollar value. It appears as though there is a growing divergence between paper and deliverable gold, and so if there are further artificial (paper) price drops, I would expect the divergence to widen.

    Your assertion, to which I responded, is related to fundamentals, and I have a very hard time understanding where the organic growth might come from, and how those in power might possibly “restructure” in a voluntary manner. In other words, based on what I perceive in the world’s most important economies, the likelihood of meaningful “organic growth” anytime soon, especially to the degree that it would undercut the (physical) gold market, is extremely remote.

      • Agreed. As are all investments. That is why reserve currency is so well favoured. Price stability and transferable. At the current gold price Australian miners are shuttering mines. So production will taper off. Will Central Banks dump physical gold to satisfy the dowry demand of the Indians, or Investment demand of the Chinese? Who knows. They certainly sold off Gold in the late 90’s at the bottom. They probably made the bottom by choice.

        I still think productive farmland is the best investment, but weather is fickle.

        Gold, whilst valued world wide is becoming a symbol of resistance. The term “Gold Bug” is derogatory and due to the extreme nature of some Gold promoters (Promoted Gold with the 2012 Apocalypse threat) this has attracted some very imbalanced types.

        I am down on Gold, but only just, so I will hope that Central Banks don’t dump. I know they have been buying equities to get better return.

        I still feel a Resource Backed currency from China will be the new World Reserve Currency. But there is also a chance of a Russian Chinese and “BRIC” currency. Most of the worlds economic growth will be in the new world, and South Africa might even lead a African Union.

  4. “I still feel a Resource Backed currency from China will be the new World Reserve Currency.”

    Don’t hold your breath on that one. Until China over-takes the U.S. militarily, there is no chance [not to mention that their financial institutions are a joke].

    They are going to take a serious hit once the wheels fall off this funny-money economy.

    • I noted the amount of gun owners in the USA exceeds the Chinese military. Even if they geared up and armed the masses of Chinese, there is no way China could take down the USA. Afghanistan would be a picnic compared to the USA guerrilla war.

      But the more I read about Russia, China, South Africa Brazil and other emerging countries getting together to create a trading block, I see the writing on the wall for the USD.

  5. In my view there have been two sets of people buying gold. The first are those who understand the fundamental reason for buying gold – that is the persistence of low to negative real interest rates. The other group is the hot money crowd who pile into things that are going up. The first group have been championing gold since the early 2000s, the latter have expressed derision all the way up, despite begrudgingly buying for speculative reasons.

    The fundamental reasoning hasn’t changed. Low to negative real interest rates continue to persist. ‘Fear of inflation’ is an inaccurate description of why it’s going up. I know it’s a widely cited rationale in the financial community, but that just suggests to me that gold isn’t widely understood fundamentally. There has been a constant, positive rate of inflation for half a century, so ‘fear of inflation’ doesn’t explain why this ‘fear’ exists now but didn’t in the 1990s. Fear of losing purchasing power of one’s savings more accurately describes the incentive for owning gold. And those fears have materialised since 2008, and indeed since 2000.

    The question is whether or not the persistence of a low/negative real interest rate will continue. You write that a new financial crisis would be bearish for gold. This is true, because a new financial crisis would be characterised by a spike in the real interest rate. We saw this in 2008 of course. What we also saw in 2008 was an unprecedented rush by central bankers to stop the financial crisis, using the reduction of real interest rates as the main weapon. Stopping the crisis also meant stopping the restructuring you say is a possibility. The two options they faced then (and still face to day) were either 1. Restructure, allowing real rates to persist at high levels and prices to fall. 2. Intervene, push real rates to the floor, attempt reflation.

    The ‘gold bugs’ (at least the ones that understand the fundamentals) are betting that 1 will never happen because it is politically unpalatable. And the events have borne that out. If restructuring was a possibility, then it would have been allowed to take place in 2008. Why all of a sudden allow the economy to restructure when it could have happened before? They’re locked into option 2 until the bitter end.

    That doesn’t mean the reflation option will work in the end, it just means that they’ll pursue it until the end. That means negative real rates and preventing deflation, which, in the end, will be positive for gold.

    • That doesn’t mean the reflation option will work in the end, it just means that they’ll pursue it until the end. That means negative real rates and preventing deflation, which, in the end, will be positive for gold.

      This is good reasoning, but even in the context of continued low real rates (right now higher than they have been for a while) there is always the danger that gold-buyers will look for other hard assets to buy including industrials, farmland, real estate, etc.

      In the longer run, I do still expect to see gold rise some more and make some new nominal highs, but I don’t know if that will be next year or later.

  6. In the world of economics, gold is like a woman, much too complex to figure out.

    Even if markets were at their least corrupt point on the curve, the number of variables that might sway the price of gold [monetary, financial, and socio-political] are infinite [especially in a global economy].

    My own take on the situation is that after 100 years of central bank inflation, ALL asset classes are inflated. How mis-priced each one will eventually be determined by the markets and time.

    The key is not in determining which assets to hold and which to sell, but instead, is to see the emptiness that is at the heart of all things. Then, it matters not whether gold is a penny or a million dollars an ounce, as real value is manifest within ones ability to thrive outside of the illusory world of money.

  7. i think you might be right. the gold price drop happened at the same time the cyprus restructuring of deposits took olace. maybe smart guys sold their paper gold because now deflation/deleveraging is more than inflating.

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