Gold rally amid slowing inflation: what’s going on?

Gold rally amid slowing inflation

Inflation eased slightly in July but remained alarmingly high. According to the latest BLS inflation report, the CPI rose 0.5% in July after rising 0.9% in June. The core CPI, which excludes food and energy, also softened, adding 0.3% in July after rising 0.9% in June. The slowdown was mainly driven by a much smaller increase in the used car index, which increased by only 0.2% (up from 10.5% in June).

However, on an annualized basis, inflation has remained virtually unchanged since June, as shown in the chart below. The overall index rose 5.4% for the second straight month (seasonally adjusted), while the core CPI jumped 4.3% after rising 4.5% in the previous month.

CPI and core CPI

So, at first glance, it seems that inflation has reached its peak. That may be true, but note that it has remained alarmingly high despite slowing across several sub-indices, including the used car index. It’s scary to imagine what would have happened if these categories had not been moderated!

Moreover, the PPI for final demand rose 1% in July (on a monthly basis) and by 7.8% over the past 12 months, as seen in the chart below. This was the largest increase since the annual data was first calculated in November 2010. Some of this increase may be passed on to consumers later, as companies have more opportunity to raise prices lately as they have little resistance to price increases.

PPI for final demand and CPI for housing

In addition, the housing index – the largest component of the CPI not hit by the pandemic as badly as restaurants and hotels – has been growing steadily since February 2021, and accelerated to 2.8% in July. Last but not least, the US Senate has passed Biden’s infrastructure plan, which could also increase inflationary pressures by increasing the money supply. All these events indicate that inflation will remain with us for now.

Implications for gold

What does the recent inflation report mean for the gold market? Well, in theory, softer inflation should be negative for gold, which is seen as a hedge against inflation and has historically shone during periods of high and accelerating inflation.

However, as shown in the chart below, the gold price bounced slightly from last week’s low, rallying about $ 50 from Tuesday through Friday. Stable (and partly below expectations) inflation appears to give the Fed an opportunity to stick to its ultra-dovish monetary policy. Indeed, according to the CME FedWatch Tool, expectations for the Fed’s tightening cycle were slightly lower than the previous week, which supported the price of gold.

Gold price dynamics in 2021

However, a bullish cheers may be premature. Inflation is still high and well above the Fed’s target. Inflationary expectations remain elevated, with some measures even broadening slightly in July. Unfortunately, it looks like the markets are no longer worried about inflation and the stock market continues to rise.

Even if inflation does fall at the end of this year, which is likely with some of the supply disruptions going away, it should not suddenly drop below 2%. Thus, the July report will not be able to significantly change the position of the FRS, especially since the US central bank is now paying more attention to the labor market. Consequently, gold investors should prepare for the upcoming QE cuts.

However, just as day follows night, upward waves follow bearish trends. The most likely macroeconomic scenario is that inflation will remain high and economic growth will slow down, which means stagflation. Indeed, a downward trend in bond yields – despite high inflation – could signal weak growth, requiring loose monetary policy. Historically, gold will shine during stagflation.

Posted by Arkadiusz Sieron 17 Aug 2021 | Translation: Gold Reserve

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