In Deflationary Environments, Central Banks Make the Price of Gold Go Up

By John Banks

After we explained why deflation is coming, some of you wrote in to ask: “What happens to gold if we get deflation?”

The short answer is that, in deflationary environments, the value of gold tends to go up, possibly by a lot.

We have empirical evidence of this from the 1930s, a decade where gold mining stocks saw stratospheric gains. The price of gold, though fixed by the government, went up in the 1930s too; when President Roosevelt revalued gold at $35 per ounce from the previous $20.67, it was a price jump of 69%.

Meanwhile, to explain why gold is attractive in deflationary settings, we first need to review the difference between nominal interest rates and real interest rates.

  • The nominal interest rate is the one you see quoted in the news, e.g. “the 30-year treasury yield is 1.47%.”
  • The real interest rate is the nominal interest rate minus inflation.
  • So if the nominal interest rate is 2%, and inflation is 5%, you would subtract 5 from 2 to get a “real” rate of -3%.

In a deflationary environment, central banks make heroic efforts to lower the real interest rate. They do this because of the painful lesson (via 1930s) of what happens when they don’t act boldly enough.

As such, when deflation is a problem, central banks very much want real rates to be negative (for reasons we will shortly explain), and do extraordinary things to make it so.

This is good for gold because, with a yield of zero, gold gives a higher return than a yield that is negative!

To better grasp the attractiveness of a zero yield versus a negative one, imagine you were presented with two choices of bank account.

  • With the first bank account, for every $100 you put in, a year later you get $100 back. Your $100 of purchasing power holds steady; you don’t add to it, but you don’t lose any of it, either. 
  • With the second bank account, for every $100 you put in, you get $95 back. You have lost $5 of purchasing power, and come away worse off than you started.

It is only logical to choose the first bank account, rather than the second, because the first one gives you your money back. The second one leaves you behind — it actually costs money to use it.

It might be that the loss is hidden. On a nominal basis, the second account might look like it still has $100 in it. With a low rate of interest, it might even have, say, $102 in it. But if inflation has taken the purchasing power down to $95 in yesterday’s dollars, the $95 is what you are actually left with today.

In effect, with a zero yield, your purchasing power is keeping pace with the times. With a negative yield, you are falling behind.

But this leads to another question. Why would inflation exist in a deflationary environment? Why would the real rate be negative in the first place?

After all, if the economy is experiencing a general decline in prices and wages — and prices continue to fall as consumers hunker down, and businesses cut jobs and wages further in a negative feedback loop — this creates downward pressure.

So, the question is, against that backdrop, why would inflation exist anywhere in the system?

The answer comes down to central banks, and the role of monetary policy and fiscal policy.

In the absence of central banks — in a total “laissez-faire” system of no intervention on the monetary or fiscal policy side — then deflationary environments would not be bullish for gold.

Instead, the economy would start to shut down, as prices fall and consumers grow fearful, leading to even more business closures and layoffs, as everyone hoards cash and reduces their economic footprint. But central banks can’t just allow that to happen — so they don’t.

Ever since the 1930s, the “deflationary downward spiral” has been the nightmare scenario for all central bankers. This is because, when a deflationary downward spiral kicks in, you can’t know when it will stop.

It is possible that an economy caught in the grip of deflation can break out of the spiral on its own. But it’s also possible that the doom loop keeps on worsening as price declines beget layoffs, demand implodes, and prices decline even further, until unemployment settles in the +20% range and society falls apart.

Then, too, the more debt an economy is burdened with, the greater the risk of everything grinding to a halt in an unchecked deflation scenario. That is because excess debt acts like a heavy weight, holding back the prospects of economic growth.

A heavy debt load absorbs capital as income streams go into debt payments rather than new investments, even as expansion projects are put off in favor of emergency savings (in part to handle the debt payments).

At the same time, large new issuances of government debt tend to “crowd out” other forms of private sector investment, creating even more economic drag.

Central bankers counteract this deflationary danger zone by deliberately creating inflation — or they try to, at least. They do this on purpose to counteract deflation as just described.

To put it another way: When an economy is sluggish and shouldering a heavy debt load, staring the deflation monster in the face, central banks badly want the real interest rate to be negative.

They try to make the real rate negative on purpose — meaning that inflation is running hotter than the nominal rate — because this state of affairs also means the debt burden is being quietly inflated away.

Even as inflation eats away the purchasing power of dollars in savings accounts, it also lightens the load of the national debt (when the inflation rate exceeds the nominal rate).

If tomorrow’s dollars are worth less, then tomorrow’s debt burden is also lighter, because the same-size obligations are met with dollars that have less value.

A lighter debt burden then makes it easier for a stuck-in-the-mud economy to grow again, so this is something deflation-fighting central bankers desire.

And so, in a weird way, when deflation takes hold, it is the automatic counterbalancing response of central bank policy that is directly responsible for making the gold price go up.

It just so happens that, in this particular situation, the very thing central banks want is the thing that makes gold go higher (real yields that are negative, and thus below gold’s yield of zero).

“You can’t always get what you want,” as the Rolling Stones famously pointed out, and that goes for central banks, too.

Sometimes a central bank’s effort to create inflation is thwarted by the sheer scale of events; sometimes the debt burden is too large, the deflationary pressure too great.

And yet, when it comes to fighting deflation, central banks are so grimly determined to avoid the “doom loop” scenario, they will do virtually anything they can to inflate away debt and stimulate growth via negative real rates — and that can mean getting crazy.

As such, the bigger and bolder that central bank policy responses get, the better it is for gold.

When the contours of this battle get super-extreme — central banks versus deflation in a fight to the death — gold goes to the moon, for reasons we’ll explain in a future piece.