It is clear that the Fed has not won the battle against inflation. With CPI rising for four consecutive months, markets do not expect another interest rate cut until September.
Isn't a "higher for longer" interest rate environment bearish for gold?
The short answer is no, because real interest rates are falling as price inflation rises.
Why do higher interest rates create hurdles for gold?
Gold is a "non-yielding" asset, which means that it does not generate interest income or dividends. Its value is determined by price appreciation. The conventional wisdom is that investors turn to bonds and other yield-bearing assets in a higher interest rate environment, creating headwinds for gold.
We saw this phenomenon play out when the Fed raised rates to combat price inflation a couple of years ago. Every time we had bad inflation data, gold sold off in expectation of more rate hikes.
But when last week's January CPI data came in higher than expected, the drop in the gold price was short-lived and it quickly recovered to $2,900. It seems that at least some investors have realized that inflation is not going to go away and need gold as a hedge against inflation despite the higher interest rate environment.
Real interest rates are falling
There is another factor at play: with price inflation rising, real interest rates are falling, even as the Federal Reserve suspends rate cuts.
The real interest rate is simply the rate you see on the news adjusted for price inflation.
To calculate the real interest rate, the quoted interest rate is taken and the CPI is subtracted.
The federal funds rate is currently at 4.5 percent. If the CPI of 3 percent is factored in, the real rate is only 1.5 percent (4.5-3=1.5). If CPI rises to 3.5 percent and the Fed holds rates steady, the real interest rate will fall to 1.0 percent.
Note that in a low interest rate environment or if price inflation is particularly high, real interest rates can turn negative. For example, if the Fed were to cut rates to 2 percent while CPI remained at 3 percent, the real interest rate would be -1.0 percent.
Note that the CPI does not reflect the entire history of inflation. The government revised the CPI formula in the 1990s so that it underestimated the real increase in prices. According to the formula used in the 1970s, the CPI is close to double the official figures. Therefore, if the BLS were using the old formula, we would be looking at a CPI closer to 6 percent. And using an honest formula, it would probably be worse than that.
This means that as price inflation increases, the opportunity cost of owning gold decreases even if the Federal Reserve holds interest rates steady. (Opportunity cost refers to the interest you could have earned if you had bought a bond instead of a gold bar).
Will the Federal Reserve raise rates?
The Fed could counteract the fall in real rates by raising the federal funds rate, but so far the central bank has given no indication that rate hikes are being considered. In fact, the consensus is that the Fed has simply suspended cuts for the time being and will likely resume monetary easing in the fall.
Given the trajectory of price inflation and the fact that the central bank never did enough to slay the inflation dragon, the central bank should probably consider raising rates to control price inflation. But the Fed is in a "catch-22" situation (complicated situation where any action taken could have negative consequences).
Given the level of debt in the economy, coupled with all the malinvestments caused by more than a decade of artificially low interest rates, the economy cannot function even in a moderately tight interest rate environment. Simply put, the economy is addicted to easy money.
This is precisely why everyone is desperate for rate cuts, and the Fed delivered in December while simultaneously talking cautiously and trying to reduce expectations of more rate cuts in 2025. On the other hand, it is clear that inflation remains stubbornly stable.
This is how Reuters summarized the dilemma:
"Extreme turmoil in the bond market has put the Federal Reserve in a bind. It can either cool longer-term inflation fears or accept President-elect Donald Trump's complaints that interest rates are "too high." It can't do both and will probably choose to address the first option, which could generate a verbal battle with the White House over the next year."
The Reuters report goes on to say, "The Fed has routinely stated that containing inflation expectations is one of its main functions" and it is "hard to imagine" the central bank ignoring signs of a revival in price inflation.
They can say it now, but it will be easier to "figure it out" when the economy begins to crack under the weight of high interest rates.
Simply put, the Fed needs to simultaneously cut rates and keep them higher. Good luck with that.
The bottom line is that even with price inflation rising and rate cuts on hold, it is highly unlikely that the central bank will start raising rates.
If they start talking about more rate hikes, this is likely to be a drag on gold, but given the current situation, inflation is under control and real rates are falling. This is bullish for gold and likely to contribute to momentum towards $3,000 an ounce.
Mike Maharrey, Money Metals