It is clear that the Federal Reserve has not won the battle against inflation. With the CPI rising for four consecutive months, markets do not anticipate another interest rate cut until September.
Isn't an environment of “higher for longer” interest rates bearish for gold?
The short answer is no, because real interest rates are falling as price inflation rises.
Why do higher interest rates create headwinds for gold?
Gold is a “no-yield” asset, meaning it does not generate interest income or dividends. Its value is determined by price appreciation. The prevailing view 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 unfold when the Federal Reserve raised rates to combat price inflation a couple of years ago. Every time we had bad inflation data, gold was sold off in anticipation of further rate hikes.
But when January CPI data came in higher than expected last week, the drop in the price of gold was short-lived and it quickly recovered to $2,900. It seems that at least some investors have realized that inflation is not going away and they need gold as an inflation hedge despite the higher interest rate environment.
Real interest rates are falling
There is another factor at play: with rising price inflation, real interest rates are falling, even as the Federal Reserve suspends rate cuts.
The real interest rate is simply the rate you see in the news adjusted for price inflation.
To calculate the real interest rate, you take the quoted interest rate and subtract the CPI.
The federal funds rate is currently at 4.5 percent. Taking into account the CPI of 3 percent, the real rate is only 1.5 percent (4.5-3=1.5). If the CPI rises to 3.5 percent and the Federal Reserve keeps rates steady, the real interest rate will fall to 1.0 percent.
Keep in mind that in a low interest rate environment or if price inflation is particularly high, real interest rates can become negative. For example, if the Fed lowered rates to 2 percent while the CPI remained at 3 percent, the real interest rate would be -1.0 percent.
Note that the CPI does not reflect the whole story of inflation. The government revised the CPI formula in the 1990s to underestimate the actual increase in prices. According to the formula used in the 1970s, the CPI is nearly double the official figures. Therefore, if the BLS were using the old formula, we would be seeing a CPI closer to 6 percent. And using an honest formula, it would probably be worse than that.
This means that as price inflation rises, the opportunity cost of holding gold declines even if the Federal Reserve keeps 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 Federal Reserve could counteract the decline 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 paused the cuts for now 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 Federal Reserve is in a “Catch-22” situation (a complicated situation where any action taken could have negative consequences).
Given the level of debt in the economy, coupled with all the bad investments 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 speaking cautiously and trying to lower expectations for further rate cuts in 2025. On the other hand, it is clear that inflation remains stubbornly stable.
Here is how Reuters summarized the dilemma:
“Extreme turmoil in the bond market has put the Federal Reserve in a bind. It can either cool long-term inflation fears or accept President-elect Donald Trump’s complaints that interest rates are ‘too high.’ It cannot do both and will likely opt to address the former, which could lead to 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” that the central bank would ignore signs of a revival in price inflation.
They can say that now, but it will be easier to “imagine” when the economy starts to crack under the weight of high interest rates.
In short, the Federal Reserve needs to simultaneously lower 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 headwind for gold, but given the current situation, inflation is under control and real rates are falling. This is bullish for gold and will likely contribute to the push toward $3,000 an ounce.
Mike Maharrey, Money Metals