Throughout the 1970s and early 1980s, American investors were gripped by a fear that their national currency would continue to lose purchasing power . There was a complete lack of confidence in the government’s ability to restrict the expansion of the money supply, culminating in panic buying of precious metals in 1979/1980 as investors desperately sought to protect themselves from the effects of inflation.
The response of the US Federal Reserve at the time was to put the brakes on money supply growth through the instigation of extremely high interest rates. This policy achieved its purpose and by 1982 the rate of increase in the money supply was trending downwards, interest rates had fallen from their peaks, and the fear of inflation had abated. Investment capital had responded to the changed situation by moving from commodities into financial assets, and the great equities bull market had begun.
Below is a chart showing the relationship between the total US money supply (M3), M3 growth rates (shown as annualised monthly figures), and the gold price, from 1972 to present time. It can be seen from this chart that the gold price tracked the increase in money supply from 1972 until 1982, apart from the 1979/1980 spike. Between 1982 and the early 1990s the M3 growth rate trended downwards to a low point of zero in 1992. During this period money flowed into financial assets as confidence was restored in the ability of the Fed to control inflation, whilst the gold price remained relatively stable (apart from the 1985 to 1987 period when the G5 tried to “fix” the US trade deficit by engineering a 40% depreciation in the US dollar, which in turn led to a rising gold price and culminated in the 1987 share market crash as foreign capital panicked out of US assets) .
Since 1993, the M3 growth rate has been trending upwards and is currently around 9%. Studies have shown that increasing money supply growth rates lead the commodities markets by 1.5 to 3 years. This means that we should have seen a rising gold price in US dollars by 1995/1996. What we have actually witnessed, however, is a declining gold price. In fact, with money supply now increasing at rates not seen since the early 1980s and the gold price falling almost continuously since February 1996, the chart shows a distinct divergence between the two . This has contributed to the currently popular belief that increasing the quantity of money no longer results in rising prices.
As mentioned at the beginning of this article, gold has performed quite well during recent years when measured in terms of almost any currency with the exception of the US dollar. In other words, gold has performed its historical function as a store of value for anyone living outside the US. However, since 1995, the time at which we would have expected to see the increasing supply of US dollars begin to have an impact on the gold price, a massive shift of investment into the US dollar has occurred. The excess dollars which have been created due to expanding US debt levels and trade deficits have been absorbed by foreign investors looking for stability. The seemingly insatiable demand of foreign capital for US dollars has been stimulated even further by the Asian financial crisis. The US is now seen as the only safe place in the world for investment.
The demand of foreign capital for US dollars and US debt has allowed US interest rates to remain at relatively low levels, given the money supply growth rate and the strength of the economy, and has supported a speculative boom in the US stock market since 1995. The US stock market is itself supported by debt, and that debt is in turn supported by the value of the stock market. A significant downturn in the stock market would most likely lead to widespread defaults on loans, a financial collapse and a severe recession. This situation will be avoided at all costs by the US political and monetary authorities using the power of the US Federal Reserve to “…discount loans and other assets of banks or other private depository institutions, thereby converting potentially illiquid private assets into riskless claims on the government in the form of deposits at the central bank.” If the Fed must purchase every non-performing loan in the US in order to avoid a serious recession, it will be done. A boom feeds on itself and is always propelled by liquidity. Once a speculative boom has occurred, liquidity must be maintained in order to avoid a bust. Look for continued high levels of US money supply growth.
The entire US financial system is based on confidence – the confidence of foreign investors who continue to pour money into US dollar assets, and the confidence of local investors who are betting their life savings on a continued stock market boom. Recent experience in Asia suggests that this extraordinarily high level of confidence in financial assets may be overdone.
In the near term, the above-ground stock of gold will most likely continue to be a hindrance to any sustainable rally in the gold price. The supply of gold will probably increase over the coming months as European CBs sell gold in the lead up to selection of the initial EMU participants in May 1998. At the same time, uncertainty regarding EMU and on-going problems in Asia should continue to support the US dollar.
source : http://www.gold-eagle.com/article/gold-versus-dollar