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m 1t Ir rr©\iffiCC n (Q) CC (G) October 12, 1979 Why Cold? The present decade, which was dubbed at its inception the "Soaring Seventies," ironically is ending on just one spectacular note - the soaring price of gold. The decade began with gold still priced officially at $35 an ounce, but between January and October 1979, gold's price climbed from $220 to nearly $450 an ounce. This 1979 increase, which ranks with the 1933 revaluation as the sharpest goldprice rise of this century, has surprised even jaundiced economic observers. " Gold bugs" see the ascent as further proof of the need to restore gold to its rightful dominance in the international monetary system. But to many skeptics, the 1979 experience confirms their belief that a speculative fever, rather than sound economic principles, rules the peculiar market for this metal. Few public officials can have welcomed the return of gold to the top of the financial pages. In principle, gold became just another commodity in the early 1970's when the u.S. stopped pegging its price, and certainly after 1974, when the u.S. authorized private ownership of gold again. But officials have had difficulty maintaining their stance of benign neglect in the face of the recent price upsurge, especially since that upsurge can be interpreted as an adverse verdict on the ability of governments to contain inflation. Officials, no less than private investors, thus wonder about what has caused the rise in gold prices, and what pol icy measures are available to deal with it. Gold's value Gold derives value from its intrinsic usefulness, from its durability, and from its relative scarcity. People prize it for its artistic, decorative, and industrial uses - essentially as a consumption good. But people also value it as an investment asset, because it can be stored without deterioration and in conven ient, portable, and transferable forms. Gold's employment for both consumption and investment purposes is illustrated by its current uses. Of the 56 million ounces of gold which became newly available to private users last year, 40 million ounces went into artistic and industrial uses (primarily jewelrymaking) and the rest went into coins, medals and bars. Of course, diamonds, silver, art objects and other durable goods similarly can be used for both investment and consumption - and in many cases their prices also have risen sharply in recent years. As with any commodity, the price of gold is determined by the amount demanded relative to its supply. But on the supply side, the picture is complicated by the fact that gold can be supplied from existing stocks as well as from new production. Indeed, gold stocks are many times larger than annual production, with perhaps 1.5 billion ounces in private holdings and another 1.2 billion ounces potentially available from public holdings. And on the demand side, fluctuations in investment demand similarly may be many times the size of annual production or industrial demand. Consequently, gold's price normally is determined primarily by investment considerations, being dependent on investors' anticipations about its future value relative to that of alternative assets.In this respect, the gold market is more similarto the stock market than to the market for a nondurable commodity such as wheat. Because the total value of privately held gold - no more than $600 billion at today's prices - is on Iy a small fraction of the world's total wealth, the shifting of other assets into gold could have pronounced effects on the price of gold. Total GN P of all noncommunist nations was roughly $8 trillion last year, and the land and capital stock required to produce this output was several times greater. Alternatively, last year's gold production - valued at about $9 billion was only a modest fraction of u.S. individuals' net savings, not to mention the savings of individuals elsewhere. Obviously, Orlinions e:<pressed in tflis ci() llot necess.arii)! tile vi€\,'Vsof the rnanageme.nt of the Federai Re::,er've ESaili( Sail Francisco, crt Reser"ve Systern. inflationary pressures only to rise even more spectacularly this year as U.s. inflation accelerated again. from either standpoint, people around the world need shift only a small portion of their wealth into gold - buy a few gold coins - to bring about a drastic rise in its price. But by the same token, even a slight decline in gold's attractiveness can cause its price to tumble, so that gold is also a potentially risky investment. These shifting gold-price trends reflect changing sentiments about national currencies. Prior to the 1970's, the purchasing powers of individual national currer.tcieswere linked, at least loosely, through the mechanism of fixed exchange rates. The dollar served as a widely accepted and fairly stable international asset. Gold's utility as an investment was accordingly limited, particularly as itwas linked to the dollarfor mostofthat period. But then, with the acceleration and divergence of national inflation rates, fixed exchange rates became impossible to maintain any longer. As a result, the purchasing powers of alternative currencies have often diverged sharply and unpredictably. However, thecoRsider., able ups and downs in currency values of the 1 973-79 period have made investment in any single national currency a risky endeavor. Not surprisingly, then, gold has increased in attractiveness as a hedge against the uncertain prospects for individual currencies, as well as against currencies collectively. For th is reason, gold has been especially sensitive to the inflation outlook, its price rising or falling with the waxing or waning of inflation fears. Why would individuals want to invest in gold? Partly, they use gold as protection against losses on other investments. Traditionally, people throughout the world have held gold against panics, wars, and other upheavals that have often sharply degraded the value of stocks and other financial assets. More recently, many investors have found that holding gold reduces the risk that their wealth will be eroded by an unforeseen acceleration in inflation. This insurance characteristic has made gold attractive as an investment asset even in periods when its purchasing power was declining in terms of commodities. Recently, of course, gold's purcha,sing power has been rising, making it a very attractive (although still risky) hedge against inflation. This has not always been true; indeed, for most of the post-World War II period, gold's price was pegged to the dollar, and its purchasing power declined with inflation. Investment in virtually any other asset stocks, silver, oreven savings bonds - would have yielded a higher return during that period. Since 1971, however, gold has risen faster in price than have commodities generally, despite sharp short-term price fluctuations which brought losses to some gold investors. Nonetheless, we can detect differences between the situation in 1 977-78 and the situation this year. Much of the 1 977-78 runup in gold prices can be attributed to U.S. inflation and the resulting decline in the value of the dollar, especially against "harder" currencies such as the Swiss franc. The dollar price of gold rose 68 percent over that twoyear period - butthe dollar price of the Swiss franc and the yen each rose about 50 percent, while the dollar price of the mark increased 23 percent. These currencies - if not quite lias good as gold" - were at least considerably superior to the dollar as inflation hedges. Gold's rise Still, gold's upward march has been neither steady nor uninterrupted (see chart). Gold prices surged in 1 971 , roughly in line with the first devaluation of the dollar, and they accelerated further in 1973 and 1 974, with the rise of world inflation and the adoption of floating exchange rates. But gold prices then fell nearly one-third in the 1 975-76 period, with the temporary weakening of In 1979, however, the situation apparently has changed drastically. Since last January, gold has risen more than 80 percent against the dollar - and by nearly as much against the yen, the mark and the Swiss franc, reflect2 ing a shift in inflation prospects throughout the entire industrial world. Inflation has speeded up in Germany, Japan and Switzerland, brought about (at least in Germany and Switzerland) by a monetary acceleration which was caused in part by their heavy market intervention in support of the dollar. Also, around midyear, fears of further inflation were fanned by the sharp increase in oil prices announced atthattime. Altogether, the upsurge in gold prices reflects the perception by investors that the inflation prospects of the major industrial countries are more closely and adversely - linked than they had been previously. Swiss fianc, putting further pressure on the dollar. Gold - and policy Thus, in the last analysis, effective antiinflation pol icies are likely to be the most effective gold policy in the period ahead. The tighter monetary-policy package adopted last weekend has promising implications on this score; indeed, gold's price fell to $375 an ounce this Monday from last week's peak of $444 an ounce. There are also signs that monetary policy is tightening abroad as well. These developments suggest that, with the containment of inflation pressures, gold's price could continue to fall as it did in -197576, because investors then would feel more secu re in putti ng thei r money back into other assets. More importantly, recent events have shown that gold's rise is a symptom, not a cause, of the uncertainty and pessimism about future economic conditions that at other times have led to fluctuations in land values, in stock prices, and in exchange rates. Investors have learned, often painfully, to switch among a variety of assets in response to their changing perceptions of the future state of the national and international economies. As a result, we have experienced frequent and often precipitous changes in the prices of such assets. Public officials feel pressured to "do something" about gold - understandably so, in view"df'its high visibility and past monetary role. Increased gold sales by the U.S. and the International Monetary Fund could help dampen the rise in gold prices. But even if sales were (say) doubled, they would remain small compared to the stock now in private hands, and thus, would be unlikely to reverse the upward price trend. Indeed, expanded sales cou Id backfi re if they were perceived as a substitute for tighter domestic economic policies. Again, any attempt to restrict private purchases of gold could also backfire, because investors might then turn back to "strong" currencies such as the mark and Charles Pigott 300 200 1 00 Consumer prices (1 967=1 00) ., .-._._0 .--------------.----------Gold price ($) 35 1950 1955 1965 1960 3 1970 1975 1979 .LSI:II.:I U018U!4seM 4eln • uo8aJO• epei\ClN o4ePI • • !!eMeH • e!uJol!1e:> • euozp'v' • e>jsel'v' Jrdr (\J) 'l!l2::> 'O:lSp U2J ues :I ZSl 'ON OIVd :I! lVISOd's'n llVW SSV1::> IS}!I:I BANKING DATA-TWELfTH fEDERAL RESERVE DISTRICT (Dollar amounts in millions) Selected Assets liabilities and largeCommercial Banks Loans (gross, adjusted) and investments* Loans (gross, adjusted) - total# Commercial and industrial Real estate Loans to individuals Securities loans U.s. Treasury securities* Other securities* Demand deposits total # Demand deposits - adjusted Savings deposits - total Time deposits - total# Individuals, part. & corp. (Large negotiable CD's) WeeklyAverages of Daily Figures MemberBankReserve Position Amount Outstanding Change from year ago @ Dollar Percent Change from 9/26/79 9/19/79 133,731 110,550 31,673 40,619 22,673 2,219 7,643 15,538 42,785 30,182 30,078 54,743 46,424 20,541 - - - - NA NA + + + + + + Weekended Weekended 9/26/79 9/19/79 Excess Reserves (+ )/Deficiency (-) Borrowings Net free reserves (+ )/Net borrowed( -) 1 15 16 + + + + + 18,663 + 18,069 + 4,359 + 8,300 135 243 203 128 97 49 44 64 1,633 155 165 576 583 203 16.22 19.54 15.96 25.68 NA NA 1,404 1,998 2,590 834 644 6,881 8,525 1,081 - 15.52 + 14.76 + 6.44 + 2.84 2.10 + 14.38 + 22.49 + 5.55 Comparable year-ago period 68 226 158 66 86 20 Federal Funds Seven Large Banks Net interbank transactions [Purchases (+ )/Sales (-)J Net, U.s. Securities dealer transactions [Loans (+ )/Borrowings (-)J - 453 77 + 562 - 234 + 503 947 * Excludes trading account securities. # Includes items not shown separately. @ Historical dataarenot strictlycomparable to changes thereporting due in panel;however, adjustments havebeenappliedto 1978datato remove muchaspossible effects thechanges coverage. as the of in In addition,for some items,historical dataarenotavailable to definitional due changes.